How Volatility Indexes Can Help Investors Gauge Bear Market Bottoms

Most experienced investors will agree that timing the market is difficult to do very well for very long. Eventually, you're just going to be thrown an unexpected curveball that unwinds all of your success. Not even most pros can do it with any consistency.

Standard & Poor's reports that in any given year, on average, more than three-fourths of actively managed large-cap mutual funds available to U.S. investors underperform their S&P 500 (SNPINDEX: ^GSPC) benchmark. That's why buying and holding index funds into and through bear markets is such a popular strategy -- it's the one that's most likely to yield the biggest net returns.

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What if, however, investors just aren't using the right market-timing tools the right way?

Well, this may be the case. The so-called volatility indexes actually offer reliable hints of when the stock market is near or at a buy-worthy low. You just need to understand how to read these clues, and appreciate that they're only an odds-making tool that isn't laser-precise.

Here's what you need to know.

What's a volatility index?

A volatility index is simply a measure of prices for a basket of put and call options. Both call and put option prices tend to rise in anticipation of near-term volatility, so when a volatility index rises, it's a hint that investors -- professional and individual alike -- expect the market to become more erratic in the foreseeable future.

And there are two key ones: the S&P 500 Volatility Index, or VIX, and the Nasdaq Volatility Index, or VXN. (The underlying stock options used to determine each of their ever-changing values is pretty clear.)

Except, that's not quite how the use of either volatility index has evolved over the last few decades. When market volatility is working bullishly in stocks' favor, the VIX and VXN tend to remain at low levels. Curiously, as it turns out, they only tend to rise to unusually high levels when investors are fearful of a market pullback, and are hedging against that pullback using options. That's why the S&P 500 Volatility Index has since come to be known as the fear gauge.

And this nuance makes for a powerful market-timing tool. See, the VXN and VIX tend to reach unusually high levels when investor fear is peaking at a major market low.

A solid track record of prediction

As the old adage goes, a picture is worth a thousand words. Three pictures are worth even more.

Take a look at the first image below, comparing the S&P 500 to the VIX between 1997 and 1999. This period, of course, includes the sizable panic-driven sell-off in July and August of 1998, when Russia's government defaulted on its debts. That development created a ripple effect that swept across the global economy, upending stocks as a result. While it was a terrifying time, as you can see, it was also a short-lived setback. Also note how the VIX was behaving around that same time. In July of that year, the VIX reached a record high, suggesting that almost all would-be sellers were already flushed out.

^SPX data by YCharts.

We saw similar action between 2000 and 2003, when the bear market following the dot-com craze of the late-1990s took hold and wouldn't let go. The VIX finally jumped to a multiyear high in mid-2002, and the S&P 500 started laying the groundwork for a reversal of the then-bear market shortly thereafter.

^SPX data by YCharts.

And the Nasdaq's volatility index has been just as telling. Although the Nasdaq Composite (NASDAQINDEX: ^IXIC) remained in bear market mode for the entirety of 2022, note that its volatility index's upward thrusts that year didn't get progressively higher. It was a subtle hint that the selling wasn't going to persist for nearly as long as it felt like it might at the time. And the VXN was also particularly telling in April this year, soaring to a multiyear high at the same time the composite itself was making a major low.

^IXIC data by YCharts.

What gives? These charts underscore the argument that most traders just aren't great at short-term market-timing. They were making their most bearish and defensive option-based bets right before or right at the market's major capitulations.

A tool with limitations, but a powerful tool nonetheless

While it's clearly capable of being a powerful market-timing tool, you must understand the big downside of using the volatility indexes in this manner. That's the fact that it requires some subjective interpretation.

See, there is no absolute VIX or VXN level that's "too high." The 40 mark seems to be one the VXN regularly reaches at buy-worthy bottoms, while the S&P 500 often makes key lows when the VIX gets near 30. There are some huge exceptions to these numbers, though, like 2009's low. The VIX jumped to nearly 80 before that bottom was in. It also jumped months before that. While most of the bear market was already in the rearview mirror by that point, that could have been a scary few more months to simply sit on stocks.

As mentioned earlier, volatility indexes aren't unfailingly precise. They'll probably never flag the exact market low, in fact, and even when they do, that won't become clear until after the fact. In most instances you'll be making some sort of judgment call on a volatility index, taking a leap of faith as a result.

Nevertheless, the Nasdaq Volatility Index as well as the S&P 500 Volatility Index are both powerful additions to an investor's odds-making toolkit. That is to say, if you understand that a clear spike to an unusually high level is often seen at points of capitulation, the VIX and VXN can certainly help confirm other clues that a sell-off has run most -- if not all -- of its course.

And when it comes to investing, even gaining a small edge is a pretty big deal.

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James Brumley has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.