Trying to chase volatility higher has been like chasing fancy footwork.

The S&P 500 last completed a drawdown of 5% or more on November 4, 2016. That ended a period of pre-election weakness that began in early to mid-August, 2016. The last drawdown of 5% or more before that occurred around Brexit when the vote accelerated a near 3-week period of weakness. The S&P 500 lost 6% before a sharp rally quickly erased fears of a negative global fallout. Since these drawdowns, the biggest drawdown for the index was a 3% loss that ended six weeks of weakness on April 13, 2017.

The S&P 500 (SPY) has all the markers of a very bullish year. Source: FreeStockCharts.com

This recent history of minimal pullbacks has occurred alongside periods of extremely low volatility (ELV). I define a period of extremely low volatility as one where the volatility index, the VIX, closes below 11. The period ends after the VIX goes 20 straight trading days closing above 11. When I first studied these periods, I made the surprising conclusion that ELV is more bullish than bearish. Conventional wisdom says that low volatility is “dangerous” and an indicator of big trouble ahead for the stock market. So I assumed that extremely low volatility would prove particularly alarming.

On the other hand, before this year, the last three periods of ELV DID proceed pullbacks of at least 5% for the S&P 500. Based on that streak, I set the clock for a 5% pullback in May. When on May 17th the S&P 500 swiftly lost 1.8% and the VIX soared an historic 46%, I thought validation was at hand. Instead, the index promptly reversed itself and ended the the month with a healthy 1.2% gain. Moreover, the period of ELV continued because volatility collapsed from 15.6 to 10.9 in just three trading days.

I soon reset the ELV clock for an August/September pullback. I also added a measure of ELVs that took into account the S&P 500’s distance from an all-time high. With that perspective, I observed a 50/50 chance that a period of ELV at or near an all-time high would precede a 5% pullback. August delivered some trouble for the S&P 500 with two days of significant selling. The VIX experienced another historic one-day pop, this time a gain of 44%. The agitation lasted longer than May’s churn including another large one-day jump for the VIX 5 trading days later. That gain was worth 32%. Yet, the VIX never closed higher than the day of the first spike. August ended with the VIX closing below 11 again, and the month even delivered a one point gain for the S&P 500. The VIX only managed to stay above 11 for 16 days, so the on-going period of ELV refused to end. The subsequent powerful September rally placed an exclamation mark on yet another bullish outcome for the period of ELV.