Does Heightened Volatility Mean the End of the Stock Rally?

"Is market volatility sending a warning?" I had asked in my Apr. 25 article. The market has emphatically answered yes. In the two weeks that followed, the Dow Jones Industrial Average ($INDU) plunged nearly 900 points, and stock exchanges around the world suffered sudden reversals.

Now that the Dow has recovered 400 of those lost points, it seems timely to ask if the Chicago Board Options Exchange Volatility Index ($VIX) has any further clues about future market direction.

The VIX index is based on the option prices of the S&P 500 stock index. When investors are worried about a potential decline, they bid up the price of "protection" against a drop -- a put option. When market players are confident of future gains, the demand for protection falls.

As a result, the VIX is widely viewed as a contrarian indicator: When the VIX spikes up, the market drops, and when the VIX declines, the market advances.

While this see-saw pattern -- if one is up, the other is down -- is readily visible when conditions are at the extremes, the relationship between the VIX and the stock market is not always so cut and dried. The interplay between volatility and stock prices is much more complex and offers us a variety of subtle clues about future market action.

Looking for Clues in the VIX

This complexity can be seen by lining up charts of the VIX and the Dow Jones Industrial Average.

A rising VIX doesn't always indicate a falling market. As I have noted on the charts, the VIX continued rising in 2007 even as the Dow advanced to new heights.

Beneath the surface, however, the rising VIX was an expression of investor unease. The sharp spike in the VIX in early 2007 and the sudden drop in the markets were clearly warning signs that complacency no longer ruled supreme.

Despite the VIX's steady rise from 10 to 30, the market continued advancing to its ultimate top in early October, 2007.

Although the market overcame the first VIX spike above 30, the three ensuing spikes were followed by a 2,000-point Dow decline. While the market can continue climbing as volatility rises, it doesn't do so indefinitely. By the time the VIX touched 30 for the fifth time in mid-2008, the Dow had fallen 3,000 points to 11,000.

Not a Mirror Image of Stock Prices

Even though the VIX remained in a range, rising to 30 and then falling back to 20, the market didn't just yo-yo up and down in a corresponding fashion -- it continued sliding in a long-term decline. This illustrates that the VIX is not a mirror image of stock prices. A chronically high VIX is an indication that a long, drawn-out battle between bulls (confidence) and bears (fear) has replaced a period of calm complacency that marks steadily advancing bull markets.

Note also the aftermath of the huge VIX spike that accompanied Lehman Brothers' collapse in September, 2008. Though the VIX rapidly fell from 80 back down to the pre-crisis level of around 30, the market didn't rise. Indeed, even as the volatility index slipped, the market continued plummeting for five more months to its ultimate bottom on Mar. 9, 2009.

The declining VIX didn't reflect a return of complacency. What it reflected instead was a growing confidence that the market was in a serious downtrend.

As the market steadily rose from the March, 2009, low in a V-shaped recovery, the VIX didn't suddenly drop back below 20. It slowly declined, hitting lower lows, evidence that confidence was returning. The VIX spikes that accompanied the market's July low didn't disrupt the volatility index's longer-term slide.

Has the Year-Long Rally Ended?

In technical analysis terms, higher highs and higher lows mark an uptrend, and lower highs and lower lows indicate a downtrend. For the bull market to resume its year-long advance, the VIX would need to fall back below 20, making lower lows as confidence once again gains the upper hand.

But if the VIX spikes up and down repeatedly within the 20-to-30 band, as it did in the fall of 2007 and the winter of 2008, that heightened level of anxiety suggests that the year-long rally from last March's low has ended.

These charts reveal that while stock prices can continue advancing as the VIX climbs, eventually gravity takes hold, and the underlying worries that the VIX reflects are followed by investors selling their shares.

They also illustrate that the VIX need not hit new highs to warn that the market has entered a long-term downtrend. It need only repeatedly keep touching the 30 level -- right where it is now -- just as it did in the months leading up to the 2008 meltdown.