Volatility Figures Accurately Predict Correction

Stock prices retreated in September following a very strong performance in August. The major market benchmarks were all lower as consumers focused on higher energy costs and the prospect of weak 3Q earnings. The Dow Jones Industrial Average (DJIA) fell 5.0%, while the NASDAQ Composite Index (COMPQ) dropped 12.7% and the S&P 500 Index (SPX) lost 5.4%. One of the hardest hit sectors was transportation, with the Dow Jones Transportation Average (DJTA) falling 7.4%. Utility shares continued to set new all-time highs, according to the Dow Jones Utility Average (DJUA), which gained 9.5%.

Last month we noted that volatility indicators were warning that the market might correct. Those indicators proved to be accurate. Additionally, we noted that the September-October period is a seasonally weak time for the markets. This combination kept us in a defensive mode. Investors have remained complacent through the correction.

Money Flows Were Negative
Our proprietary money flow indicators were negative last month, indicating that more funds came out of the markets than were invested. This was partially the fault of the rising U.S. dollar, which kept new foreign contributions out of the markets. Adding to the burden were earnings warnings, which knocked some issues sharply lower.

Other internal market indicators did not fare much better. Our NYSE and NASDAQ Advance-Decline indices and New High-New Low indices were also negative last month.

Most of the market benchmarks are in negative territory for the year thus far. This is an indication of the difficulty that the markets have had this year. A slowdown in the rate of growth, prompted by Federal Reserve monetary tightening, higher energy costs, and a bit of transition following several strong growth years, has caused the markets to gyrate.

We also note that investor speculation and short-term trading have dropped from their peaks. The dream of never-ending appreciation of Internet stocks turned into a nightmare reality, which speculators will hopefully not forget in the future.

Trick or Treat
Concerns about economic and earnings growth should dominate the markets during the next several weeks. Companies will begin the task of reporting quarterly results this week, and analysts will make adjustments to their yearly numbers and next year's projections. This could result in a rise in volatility as investors shake out their portfolios during the autumn cleanup. It is fitting that Halloween ends the month with goblins and witches casting their spells over the markets.

The S&P 100 Implied Volatility Index (VIX) gave a short-term oversold signal on September 22. The rise in the market last Thursday quickly reversed that reading, and the indictor is now in overbought/negative territory.

Ivolatility.com's reading of implied volatility for the S&P 500 Index (SPX) remains at a negative 17.5% reading at this time, indicating that caution is warranted. Additionally, the 30-day historical volatility has fallen to 12.2% this month, setting a new 12-month low (see chart). There is too much complacency among investors, indicating that the slowdown in the economic growth rate of the economy, and the rise in energy prices have not scared the average investor, yet. The question is, will the upcoming release of earnings numbers be the turning point, or will it be next month's presidential election? A third possibility might be that complacency becomes the correct strategy. It's anybody's ballgame. Remember, New York has four winning teams right now!

Chart courtesy of www.ivolatility.com
Chart courtesy of www.ivolatility.com