Purify This

So one argument I was making re. the value of the VIX is that you need to determine whether it tells you something you don’t already know. Well, it looks like it does, and actually better than other indices. I’ll let CXO Advisory explain.

It is arguable that sentiment indicators derive substantially from what just happened in the stock market and that they therefore add little or no value to price action itself in predicting future returns. In their May 2009 paper entitled "Purified Sentiment Indicators for the Stock Market", David Aronson and John Wolberg investigate this thesis by removing the influence of recent stock market price dynamics (defined by 18 variations of price velocity, acceleration and volatility) to produce multiple "purified" versions of each of five sentiment indicators: (1) the CBOE Implied Volatility Index (VIX); (2), the CBOE Equity Put-to-Call Ratio (PCR); (3) the American Association of Individual Investors Bulls minus Bears (AAII); (4) the Investors Intelligence Bulls minus and Bears (INV); and, (5) Hulbert’s Stock Newsletter Sentiment Index (HUL). They then measure the power of the purified sentiment indicators to generate profitable trading signals by testing 100 signaling rules for each indicator. Using data for the five sentiment indicators from initial availability (ranging from January 1963 to July 1987) through October 2008, along with contemporaneous daily closes of the S&P 500 index, they conclude that:

Since January 1990, specific past price dynamics (the most predictive) predict all five raw sentiment indicators, with R-squared statistics ranging from from 0.27 to 0.70. The most predictive past price dynamic varies from indicator to indicator and somewhat overstates dependence of the sentiment indicators on past price action.

Poll-based sentiment indicators (AAII, INV and HUL) are especially sensitive to the recent simple stock market trend (velocity).

Purification generally reduces the drift and stabilizes the volatility of the sentiment indicators, suggesting greater usefulness of purified indicators for fixed threshold trade signaling.

However, purification reduces the profit factor (ratio of gains from profitable signals to losses from unprofitable signals) of trade signals for four of five sentiment indicators (all but VIX), bringing into question whether these indicators augment the inherent predictive power of price dynamics. Profit factor analysis on past price dynamics alone suggests that the poll-based AAII, INV and HUL are proxies for simple price trend (velocity) and that AAII, INV, HUL and PCR add minimal value to price-based indicators.

In contrast, purification significantly enhances profit factors for VIX signals, implying that VIX contains predictive information above and beyond price dynamics but that past price dynamics mask this information. Purified VIX is superior to all other indicators tested.

The charts are above. PLEASE click thru to CXO in case they mind that I ran their chart (the occasional contact I have with them they’re pretty amenable).

But here’s the irony. The VIX does in fact contain valuable information above and beyond simply moving with (really in opposition to) the SPX. But that info is not readily apparent by just looking at the VIX. It sounds kind of similar to something we say over and over again here. Namely that the VIX tells you the most when it does not confirm something you can already see via just equity index prices.

In other words, those days where you see the SPX strong and the VIX relatively strong as well, take a note. It probably has bullish implications. In fact in my relatively unsophisticated statistical work in my book (available for pre-order now on Amazon) I did find that to be the case.

It also brings to mind the bass ackwards excitement about the VIX breaching 30 last week. That’s a perfect example of the VIX NOT telling you anything you didn’t already know from watching the extended rally courtesy of Ben Hank and Tim’s pump and dump scheme……I mean the perfectly natural buying interest.