By now you all know that the TradeStops VQ is a powerful metric for understanding volatility risk in individual equities. Today, I have a new and exciting application of the TradeStops VQ to share with you. I’m going to show you how it can forecast future stock market volatility … and how it is currently forecasting stormy waters ahead.
Most of the time when we are looking at VQ, we see a snapshot of it at a fixed point in time. Today the VQ on Walmart is 12.8%. On GDX it is 37.2%. Etc. It’s very useful to see these static snapshots of VQ. It helps us to understand the risks that we’re facing today. It helps us know where to put our stops, when to get back in and how much to invest.
But it’s also very powerful to look at how VQ changes over time for individual equities and indices. There are periods when volatility is contracting and VQ is going lower. There are periods of time when volatility is expanding and VQ is going higher.
It’s particularly interesting to look at when the trend in VQ changes from one direction to another. Right now is just such a time in the S&P 500 itself.
The following chart shows the price history of the S&P 500 on top and the weekly changes in the VQ of the S&P 500 over the past 10 years.
I’ve put a red horizontal line right at 10% because I’ve found that when the VQ on the S&P 500 falls below 10% and rises back above 10%, it is often a sign of a big increase in volatility to come. You can see how that happened between 2007 and 2008 … and you can see how it happened again in 2015 – 2016.
Let’s zoom out now and take a look at how these dips below 10% for VQ have played out over the past 40 years …
It’s clear to see in the chart above that EVERY time the VQ on the S&P 500 has fallen below and then risen above 10%, it has been followed by an expansion in volatility of 50% to 100% in the following 6 to 12 months.
I find that very interesting!
There are a couple of other interesting things to note in the chart above. First of all, it’s important to note that there is a LOT of data in the chart above. These moves play out over a period of years … not weeks or days. This doesn’t necessarily mean you need to run out and buy the VIX tomorrow.
The second really interesting thing in the 40 year chart above is that increasing volatility doesn’t necessarily mean lower prices! Look at 1978 and 1996.
Of course there are often waterfall moves in price that lead to expanding volatility … like we saw in 1973, 1987 and 2008. That may be what we’re looking at in 2016 … but not necessarily! Just sayin’ …
The S&P 500 has been range bound between 1825 and 2100 for more than two years now. Even more amazingly, it’s been range bound between 2000 and 2100 for 4 months now. You can see that very clearly in the volume-at-price chart I’ve been regularly sharing all year long.
I think that is about to change … I just don’t know in which direction.
The low risk play is definitely on the bearish side right now. There are genuine geopolitical reasons why economies could falter and stocks could fall across the globe. I get that. The bears have the advantage of being able to use a very tight stop on their shorts here because prices are already near the top of their range.
My time cycles analysis also suggests that at least a temporary correction in the S&P 500 could be in the cards:
And I still think that there’s something to my Ameribuy! thesis which suggests that the fact that the good old U.S. of A. is still the world’s least bad option.
Whether the bulls or the bears ultimately emerge victorious, I’m still not quite sure. I’m pretty sure, however, that we’re in for a period of expanding volatility for the remainder of 2016 and, quite possibly, beyond.
Richard M. Smith, PhD
CEO & Founder, TradeStops