MW VIX signals stock rally 'healthy' for now. Here's how to use it to spot a bubble.

By Christine Idzelis

'There seems to be a lot of enthusiasm for stocks post-election and the VIX will be one way we monitor U.S. equities into year end,' says DataTrek Research's Nicholas Colas

The recent surge in stocks on the heels of the U.S. election has so far coincided with a drop in Wall Street's fear gauge, as investors watch market volatility for clues as to whether the rally will hold up.

The Cboe Volatility Index VIX was down more than 1% Tuesday afternoon at 14.76, with the gauge trading below both its 200-day and 50-day moving averages, according to FactSet data, at last check. The index, which trades under the ticker symbol 'VIX,' closed at about 15 on Monday.

That's "a healthy sign and its readings should continue in that vein through year end," Nicholas Colas, co-founder of DataTrek Research, said in a note emailed Tuesday. "Don't trust stock market rallies built on a foundation of persistently higher than average volatility."

The S&P 500 SPX has climbed more than 25% this year based on Tuesday afternoon trading. That includes a rally of around 5% so far this month, with a 2.5% jump on Nov. 6 when the results of the U.S. election showed Donald Trump had won the vote to become the next president.

"There seems to be a lot of enthusiasm for stocks post-election and the VIX will be one way we monitor U.S. equities into year end," said Colas.

Investors seem confident in the bull market, based partly on the VIX's low reading. Colas looked to history as a guide for when the volatility index may help spot a bubble in the stock market.

"One would think that strongly bullish sentiment would make for exceptionally low VIX readings, since its direction is inversely correlated with stock prices," but that's not always so, Colas said.

"Rallies built on an elevated VIX signal a bubble," he wrote. "If it starts to run +20 as stocks continue to advance, that would be a bad sign."

The S&P 500's valuation is high, with a price-to-earnings ratio of around 22 times forward 12-month earnings, according to DataTrek.

"Leading up to the top of the 1990s dot com bubble peak for the S&P 500 in March 2000, the VIX had been running above its then longer run average all through 1999," Colas said.

The VIX's current long-run average is about 19.5, the DataTrek note shows. "Even with 2 notable crises in the 1990s, the average VIX close from 1990 through 1998 was relatively low, at 17.8," said Colas.

The S&P 500's closing high during the dot-com bubble was March 24, 2000, with the VIX finishing that day at 23.3, according to Colas. "While that alone was not [terribly] unusual in the context of the last 15 months, it did prove to be the top on the S&P 500 until 2007," he said.

The recent rally in U.S. stocks was taking a pause Tuesday afternoon, with major benchmarks trading lower. The S&P 500 was slipping 0.2%, while the Dow Jones Industrial Average DJIA fell 0.8% and the Nasdaq Composite COMP dipped 0.1%, according to FactSet data, at last check.

"The VIX most often bottoms in November and December," said Colas. "If it trends higher over the remainder of the year as stocks continue to advance, that would be a troublesome signal, since it is reminiscent of 1999."

Read: Why this analyst lifted S&P 500 target to 7,000 for 2025 and cited 'meltup' risk

-Christine Idzelis

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November 12, 2024 15:56 ET (20:56 GMT)

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