The holy grail of investing is a market timing method that gets you out of the market on bad days and gets you in for the good days. There are innumerable methods for doing this, ranging from slogans, Sell in May and Go Away to closely guarded multi-factor proprietary algorithms.
The worst methods have no apparent causal relationship between the predictor and the thing being predicted. A non-stock market example is the “Redskins Rule.” Between 1940 and 2008 if the Washington Redskins football team won the Sunday before the election the party that won the popular vote in the prior election won the presidency -- 17 out of 18 times. After Obama’s re-election this rule is now 17 of 19. These non-causal rules are just coincidence, if you look at enough data you will find them everywhere -- and they mean nothing.
Most stock market timing methods are based on price action -- things like moving averages, technical chart indicators, price/earnings ratios, or pattern recognition. At least they have some sort of connection to the stock market.
Recently I’ve been looking at volatility metrics for predicting market action. The CBOE’s VIX index gets a lot of attention, but using absolute values of the VIX to trigger investments is almost certainly useless. On the other hand, volatility prices over different time frames, often called the term structure, does show significant predictive value.
In a truly bearish market the short term expected volatility, typically cheaper than longer term volatility, climbs higher than the longer term value. This behavior is shared between flavors of VIX (e.g., the one month VIX & its three month version VXV), VIX futures, and the implied volatility of same strike options of different months. The chart below from VIX Central shows the progression in VIX futures prices from before the May 6, 2012 Flash Crash through the 7th.
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