Does Lower Volatility Signal a Market Correction? Not Necessarily

The Chicago Board Options Exchange's Volatility Index, also known as the VIX, has been trending lower lately, which has some analysts predicting a stock market correction between late January and the end of February. But a low VIX ($VIX.X) doesn't necessarily mean a market correction is imminent. In fact, in the current economic environment, it could suggest a continuing rally.

Over the last two months, the VIX, which measures the variance in the prices investors pay for options on the Standard & Poor's 500 index, has dipped several times toward 15 -- a level not seen consistently since July 2007, toward the end of the last bull market. The VIX had also dipped back into the 15 range in April 2010 when the market began the deep correction that lasted through the summer and included May's "flash crash," when the Dow Jones Industrials dropped nearly 1,000 points in less than 30 minutes.

Last Friday, the VIX closed at 15.46, then rose to 15.87 on Tuesday and jumped up to 17.60 on Wednesday. If the VIX continues to dance around the 15 range, some analysts believe a market correction is almost assured. The Wall Street Journal reported that Michael Purves, chief market strategist at BGC Financial, predicted a market decline of 7% or more by the end of February. Other analysts have predicted declines larger than that.

But other market watchers view the 15 level for the VIX in a different light.

Low Volatility Is Relative

"There's been a lot of talk about what that low VIX number means," says Ryan Detrick senior technical strategist for Shaeffer's Investment Research.

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Detrick suggests that because many of the market fundamentals have improved from where they were in April, the VIX dropping to 15 might not portend the same market behaviors it preceded last year. Corporate earnings are still trending upward, investors are starting to move money out of fixed-income investments into equities again and projections for GDP growth in the U.S. for 2011 have improved. While investors are still quite concerned about volatility, it seems that they have accepted the higher level of risk in today's market. In fact, the current bull market hasn't slowed since it began a sustained upward move in September.

"The consensus is that a VIX of 15 is considered a little too low," he explains. "But if this is another good bull market, which we think it is, maybe a VIX of 15 isn't as low as people think it is, and volatility could actually continue to trend lower."

Detrick points out that during the last bull market from 2004 to 2007, the VIX traded between 10 and 15 for three-and-a-half years. In fact, the VIX dropped below 10 on a number of occasions during that bull market.

"During the last bull market, 15 was actually considered high," he says.

Bearish on VIX, Bullish on Stocks

Detrick says Shaeffer's Investment Research believes the VIX will eventually work its way down to 10 again, and the potentially lower volatility could result in higher stock prices as skittish investors continue to return to the stock market. He's betting that levels below 15 will propel the stock market higher, thus sustaining the current bullish trend.

"We've been bearish on the VIX and bullish on the market for quite some time," Detrick says.

Randy Frederick, director of trading and derivatives for Charles Schwab, says that while the VIX may make large single-day jumps from time to time, he expects that during earnings season, any big moves in the VIX will be caused by earnings report news from industry bellwethers. Since that news has generally been positive, the VIX will likely remain low.

"Despite remaining at historically low levels for the past couple of months," says Frederick, "the various indicators associated with the VIX are not yet showing any signs of an impending spike in the VIX, and the typical market correction that would accompany it."