- A divergence between the S&P 500 and the VIX fear gauge is sending mixed signals to investors.
- The S&P 500 has fallen to a new low over the past month while the VIX has remained subdued below 30.
- Some investors are looking for a surge in the VIX for the all-clear that it is safe to buy stocks.
A divergence between the S&P 500 and the VIX fear gauge is sending mixed signals to traders as they try to identify a bottom amid the market's ongoing correction.
Typically the VIX has an inverse relationship with the broader stock market and surges higher as the stock market falls lower, and vice versa. But while the S&P 500 has fallen to new lows in May, almost hitting bear-market territory as it neared a 20% decline last week, the VIX index has remained subdued below the 30 level.
That's the same level the VIX was at last month when the S&P 500 was about 10% higher from current levels, signaling to some traders that there has yet to be true capitulation that would give an all-clear to buy stocks again.
Capitulation describes the moment when the average investor reaches their max pain limit during a downtrend and throws in the towel by selling out. That capitulation moment is typically seen when the stock market finds its bottom, and it usually occurs when the VIX surges above the 40 level.
Still, some view the divergence between the VIX and S&P 500 as a bullish signal that the stock market can stage a continued relief rally from oversold levels if the VIX remains below 30 and trends lower towards the 20 level.
"The bias of the VIX is lower in the near term, with its 20-day MA having rolled over, following a test of resistance at the highs in the mid-30s. At the same time, we expect the oversold bounce in the SPX to persist in the near term," Fairlead Strategies' Katie Stockton told Insider on Thursday.
But that doesn't mean the stock market is out of the woods yet, just that it is primed for a short-term relief rally after having dropped seven straight weeks in a row.
"We would not read into any day-to-day divergences of late with this in mind. The VIX has not indicated capitulation yet, and we do think this will occur in the months ahead above the resistance in the mid-30s," Stockton said.
Stockton's view is echoed by Chris Murphy, the co-head of derivatives strategy at Susquehanna International Group. Murphy is looking for a combination of high trading volumes and a VIX reading of 40 or above to signal that the market may have found its bottom.
"I am looking for a surge in volume as well as VIX and SPX realized volatility into the 40s to feel more confident in a bottom. History has shown that markets have rebounded after volatility spikes like that. Right now markets feel more like a buyers strike with volumes relatively light," Murphy told Insider on Thursday.
While many traders would like to see a VIX spike into the 40s to confidently say that a bottom has been reached in stocks, it isn't a requirement, as time and time again the market has shown its propensity to deviate from its traditional playbook and do what few expect it to.
Urban Carmel of UBS highlighted this dynamic on Twitter earlier this week. "Not sure where the '$VIX must be +40 for there to be a low' comes from. [Of the] six prior corrections of 10% to 20% since 2009, 3 bottomed [with VIX below] 40. The 1990 bear market bottomed with $VIX at 36," Carmel tweeted on Wednesday.
The VIX fell to 26.31 Friday after hitting a high of 36.64 earlier this month.
