Tuesday, May 22, 2007

High Positive Correlation Between VIX and SPX Often Signals Market Weakness

For the benefit of those who may not have been following this story, I will backtrack a little before diving in.

I first talked about the implications of a positive correlation between the SPX and VIX back on April 26th in “Divergence, History and Tells,” when I noticed a change in the recent pattern of SPX and VIX correlations. In a follow-up post on May 4th, “Predictive Value of SPX and VIX Correlation: First Pass,” I offered a preliminary conclusion:
“The bottom line is that a highly correlated SPX and VIX does not bode well for the SPX across all the time frames I have been looking at, which start at three days and go out as far as three months.”
Since the second article, I have been crunching numbers and playing around with various correlation metrics and have concluded that the period of high SPX-VIX correlation was focused primarily from April 25th to May 10th and reflected some high readings not seen since 1998. One noteworthy aspect of the recent period of high correlation was its relatively long duration, again something that has not been observed in some of the correlation metrics since March and April of 1998.

Even though today is setting up to be a rare instance of back to back sessions of positively correlated SPX and VIX readings, the big correlation spike now appears to be in the rear view mirror, at least from a statistical perspective.

In looking at past periods of high positive correlations between the SPX and the VIX, it is notable that the SPX generally performs well below its historical mean for up to three months following the high positive correlation period. I also find it particularly interesting that a period of significant underperformance is often associated with 20 trading days following the peak readings. If you consider April 25th to be the first day of these peak readings, then knowing that tomorrow is day #20 should at least give you some fodder for contemplation.

In sum, always be careful with any trading strategy that assumes a freight train is about to make a U-turn…but understand that it never hurts to be fully prepared for the possibility.


Anonymous said...

If you look at the results of the signals over the S&P 500 that I calculated (not just VIX, but other similar signals), it looks like you can reduce the "freight-train issue" by just accumulating shares each time a new signal occurs, and selling them when the sell finally comes.

You can see in the table at the bottom that there are 4 buys in 1998 and 1 sell. The first 3 weren't correct U-turn indications, but they still returned above average for their respective period lengths.

-Michael J Bommarito II

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FYI - intraday on Tue, the aggressive Put buying is tilting the TOF Ratio near its warning track. This could change dramatically by the close, but as of 1pm it's corroborating your "Day 20" observation.

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