Does a Rising Volatility Index Mean the Bull Market Is Over?

Is the market pullback that began on April 26 and accelerated wildly with Thursday's 1,000-point freefall and recovery just part of a normal bull market correction, or is it confirmation that a bear market has begun?

For traders who follow the VIX ($VIX) -- the S&P 500 Options Volatility Index -- the answer remains largely uncertain, but they expect that the indicator will soon give them a clearer picture of what's developing. While some view the VIX as a predictor of investor sentiment about volatility in the broad market over periods of 30 days or more, others believe the VIX is a better predictor of short-term moves in the market, though on occasion, the aggregate of many short-term moves will evolve into a longer-term trend. Whether this week's downward movement reflects a short-term or long-term trend depends on how you chose to interpret the numbers.

Randy Frederick, director of trading and derivatives for Charles Schwab, says that while it might be days or weeks before we learn exactly what caused the market volatility that manifested itself in Thursday's brief freefall, he does concede that the VIX was trending higher over the past 10 days, suggesting that some sort of correction to the markets was in order. In fact, Thursday's 31% move in the VIX from 25 to 32 was similar to the 30.5% jump in the VIX during the last market pullback in late January. Since the VIX tends to move in the opposite direction of the market, any sharp increase in the index could predict a market correction, while steady decreases in the index forecast market rallies.

"The VIX was already on the rise and had been for several days," says Frederick. "It had already risen into the mid 20s from 15 prior to yesterday's move."

Market Fundamentals Remain Strong

With the VIX jumping again Friday morning from 32 to above 41, Frederick believes the index is simply reflecting a short-term downturn in the market, especially since the VIX has not been trending higher for a month or more. The upward movement in the VIX corresponds with the 9% correction the S&P has experienced since April 26, he says. Since a normal bull market correction is between 7% and 10%, Frederick believes what is taking place right now appears normal. Others are more concerned because the VIX is now at its highest level since May 2009, shortly after the current bull market began.

"As uncomfortable as it makes people, these types of corrections are actually healthy in a long-term bull market," he says. "The only way we will see a continual rise in the VIX over many days or many weeks is if the bull market is over and we go into a sustained bear market."

Frederick says it is doubtful that we've just entered a bear market because market fundamentals are still strong, but he concedes that there are so many uncertainties it is hard to predict where the market will move next week. Given that it is still unclear why the market dropped 1,000 points in 15 minutes on Thursday, whether Greece's debt issues have truly been resolved, or whether the recent string of good economic reports really means the economy is improving, he anticipated continued weakness late Friday as traders decided whether this week marked a normal market correction or the start of a bear market.

By 2:30 p.m. Friday, the Dow was down around 140 points and other U.S. markets were charting proportionally similar declines. "It's likely that traders specifically are going to be a little bit uncomfortable being very long going into this weekend," Frederick says, "because there are too many uncertainties and that's what markets don't like."