WATCH: The 4 Stage Stock Market Cycle


How you can see into the stock market's future.

By Chris Rowe October 27, 2006 Facebook Logo Twitter Logo Email Logo LinkedIn Logo

Did you know that there is a way you can see into the stock market's future?

If I'd been writing in The Tycoon Report in October of 2002 or March of 2003, I could have told you that we were looking at a bear market bottom, and it was time to BUY. Any of my old clients can vouch for me on that. (Don't you hate hearing people say things like that?)

Have you ever heard of the CBOE Market Volatility Index?

Well, it's not just another one of the gazillion different indicators that traders look at.

It is the market's best prediction of near-term market volatility.

If you don't use this indicator, you are missing a key weapon in your investment arsenal. If I am the guy who makes you aware of this for the first time, then I may earn a Tycoon Report reader for life.

The way to access the quote or chart may vary depending on what quote system you use, but to point you in the right direction, if you are using "Yahoo Finance" the quote looks like this: ^VIX. (The "^" is on top of the 6 on your keyboard.)

Most quote systems will show you the index under the ticker symbol VIX. The old version of the VIX can usually be found under the ticker symbol VXO.

This indicator is known as the "investor fear gauge" because it reflects investor's best prediction of near-term market volatility, or risk.

You should save a quote of the VIX somewhere on your computer.

How can you use it to predict market bottoms?

The "VIX" starts to rise during times of high stock market stress, and falls as investors become complacent.

Before I get into this, just remember that there is no "holy grail" to investing. But that being said, this technical indicator is extremely accurate.

It isn't something that is used every day, so I find that most traders/investors who know about it actually forget about it, and then thank me when I remind them to check it.

So here it is ...

The first thing to understand here is that the VIX is what we call a contrarian indicator. In other words, when it is showing us that investor stress/fear is at high levels, then a bear market is most likely at or near a BOTTOM.

When the index shows us that the market is very complacent, then you should be cautious. The index is a MUCH better guide for predicting market bottoms than market tops. I wouldn't recommend trying to predict a market top based on the VIX, but it is always smart as an investor to know when the market is overly complacent.

The first VIX (Symbol: VXO), introduced by the CBOE in 1993, was a weighted measure of the implied volatility of eight S&P 100 at-the-money put and call options.

Ten years later, it expanded to use options based on a broader index, the S&P 500, which allows for a more accurate view of investors' expectations on future market volatility.

I'll make this simple here ...

When the VIX is up, it means that people are willing to pay more for options (most notably, put options), which are largely used as a way to hedge your stock portfolio against losses, or to reduce the volatility of your portfolio.

When the premiums for options are higher (and the VIX is higher), it means that investors expect more volatility.

When the VIX is at levels greater than 30 (which is considered high), it is associated with a large amount of volatility due to investor fear or uncertainty. The majority of the time, this is when you want to buy stocks.

When the VIX is at levels below 20, it is associated with less stressful, complacent times in the markets.

When the VIX is over 40, it means that there is a TREMENDOUS amount of fear in the market. I mean, people think that the sky is falling and the world is coming to an end.

That, my friends is a HUGE indicator that we have hit a bottom, and you should drop everything and BUY.

Look at the two charts below.

The top chart is of the S&P 500 from 1997 to May 1, 2006. The bottom chart is of the VIX, in the same exact time period.

Look closely. Doesn't it look like the same chart, flipped upside down?

Notice how when the VIX is at its highest points (usually between 40 and 50), it has marked a bottom of a bearish trend. This is when most people are sellers, and if you remember what you read today, it is when you will be a buyer the next time it happens.

Look at yet another chart of the S&P 500 versus the VIX from May 1993 to December 1998. As you can see, the right time to buy was when the VIX spiked due to investor fear.

"Okay Chris, so what's your point here?"

First of all, you should notice that the VIX has been under 20 since mid 2003. Hopefully that will drive home my point that the VIX is to be used to call market bottoms, and not tops.

If you sold stocks when the VIX went below 20, you would have missed a 30% gain on the S&P 500, and a 54% gain on the NASDAQ.

But you should also notice that the VIX has recently spiked from 11.39 to 15.80 since May 5th.

You should watch the VIX closely now, because the last THREE times that we saw the VIX pop to these levels were in October 2005, April/May of 2005, and at the end of October 2004.

Those dates coincide with the last three market bottoms (see below). This time is a bit different though. While the market looks attractive after seeing your favorite stocks at levels not seen in months, I would really keep this knowledge that you have on the VIX in your back pocket for the time being. When the VIX breaks 20 and moves closer to 25, I'd start looking very seriously at taking several new positions.

If you do see an oversold stock that you want to jump into while the VIX is under 20, be sure to only take the first half of your position, and wait for a bigger sell-off.

This way, you may not make as much if the stock trades higher immediately, but you also reduce your risk, and give yourself an even better purchase price if the stock sells off.

I personally think the market needs to dip just a bit more before the next rally, but what do I know?

Remember, as I said at the beginning of this article, there is no "holy grail" to trading or investing. Use this as one of many guides.

The fact that the VIX has been at historic lows lately means that when you buy on the stock market dips, be extra cautious. This will be a trader's market for sure.

You're going to want to be in and out, but the trading profits will come much easier if you take a look at the VIX at least once or twice a week.

I hope this will help to give you a little more perspective. Watch the VIX, and read more about it.

In my article next week, I'll tell show you how the historically low VIX is currently presenting us with a huge opportunity to make big profits on options. (That's another story.)

See ya then.

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