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VIX Says Brace for Some Volatility

Its been a relatively calm summer for the stock market. Trading volumes have dried up. And prices have been caught in a trading range for the better part of five months. This was a welcome change from the extreme volatility seen over the spring as the European debt crisis and the May 6 flash crash plunged global financial markets into chaos.

As a result, the CBOE Volatility Index (VIX) known as Wall Streets fear gauge has fallen from a high of 48 in May to trade in the 20s all summer long. But now, with stocks stalling at significant overhead resistance levels, the VIX is perking back up again.

On Wednesday, the S&P 500 added four points. Given the inverse relationship between the VIX and stocks, such a rise should have resulted in a 1.9% drop in the VIX. Instead, the VIX gained 2.5%. Prior occurrences where the VIX moved higher along with prices tend to mark important tops for the stock market. This is likely due to savvy Wall Street insiders adding portfolio protection via the options market, pushing up the VIX, ahead of a decline.

You can see this in the chart above. In the top pane is the S&P 500. In the bottom is the seven-day rate of change of the VIX. This indicator is positive when the VIX is above its level seven days ago. Crossovers from negative to positive territory have done a pretty good job of warning of trouble over the past year.

What this means is that after a period of relative calm over the past few months, volatility is likely headed higher. And with that, stock prices should come under pressure. Thats the bad news.

The good news is that volatility should resume its downward trend this fall at least, thats what history suggests. This is based on the work of Tom McClellan of the McClellan Market Report, who finds that the VIX tends to follow the path of short-term interest rates on a two-year lag. Right now, the VIX is chewing through the interest rate volatility we saw back in late 2008 you know, bank bailouts, the collapse of Lehman Bros. and all that.

But as time goes on, the VIX should reflect the drop in interest rates to near 0% as the Federal Reserve injected cash into the financial system to stave off economic disaster. As volatility wanes, stocks should catch a bid. I recommend using the developing stock market correction as a buying opportunity as we head into the end of the year with a specific focus on technology stocks, especially semiconductor names like Intel (NASDAQ: INTC ) and Cypress Semiconductor (NASDAQ: CY ).

Disclosure: The author does not own or control a position in any company mentioned.

Be sure to check out Anthonys new investment advisory service, the Edge , which is launching this month. He can be contacted at anthony.mirhaydari@live.com . Feel free to comment below.