Here we go again. Market volatility is near the bottom of a multi-decade range. We therefore anticipate a slew of “analysis” predicting an important market top. But this line of thinking is seriously flawed. Below is what we said in June 2016. And there’s no need to change a word.
We keep hearing that today’s near-record-low volatility is signaling an imminent market top. To test this proposition, we examined implied volatility back to 1986 using the VXO index. (VXO behaves similarly to VIX, with the advantage of a longer track record.)
Friday’s VXO reading of 10.3% was a near-record low. Weekly readings below 11% are rare events, occurring only 3.6% of the time. The chart below flags all such occurrences in red. Most of the time, the market has moved significantly higher after it enters a super-low volatility environment.
We conclude, therefore, that today’s low volatility is not sufficient reason for a market top. Historically high volatility, on the other hand, is a good indicator of market bottoms.
Detecting market tops is difficult work, so all analysis is welcome. But let’s make sure we support our reasoning with factual evidence. Many tests prove negative… and that’s okay too. It’s good to know what doesn’t work, as well as what does.