Tuesday, September 1, 2015

Looking at the VIX

As you may have noticed, the VIX futures market has moved into "backwardation" during the course of the market's recent sell-off.  Backwardation occurs when near-term VIX futures become more expensive than longer-term VIX futures (in this case the 3 month VIX contracts).  This is a fairly rare event and suggests that traders are betting that volatility in the future (3 months out) will be lower than it is now.

Since 2012, when this situation has occurred it has been a rather reliable indicator to buy the market. This makes sense because, as we've frequently mentioned, the market has ended nearly every pullback with a sudden V-bottom over this timeframe.  In fact, in the chart below you'll see that if you were to employ such a strategy since 2012, you enjoyed really consistent, positive returns over the near and intermediate term.  Note: VXV represents 3-month volatility.

However, we've expressed some concern in recent days that this pullback/correction appears to be reminiscent of the more prolonged pullbacks that we saw from 2009-2011 and today's plunge further reinforces that belief.  So with that in mind, we ran the same backwardation study as above for 2009-2011. You'll see that the S&P's returns over the first 5, 10 and 20 days came in far more muted than the 2012 to early 2015 market.  However, returns for the index after 50 days were higher.

Since today's action makes the potential for a V-bottom less likely, it looks as if we could be in for a choppier path that more resembles the data in the 2nd chart shown.  Something to consider over the next couple of months.

Ryan Worch is the Managing Director of Worch Capital LLC. Worch Capital LLC is the general partner of a long/short equity strategy that operates with a directional bias and while emphasizing capital preservation at all times.

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