From Price Action Lab:
An Increase in Volatility May Not Signal a Stock Market Top
As stock market volatility is decreasing towards historic lows, some may think that a sudden increase will signal a top. But history shows that although some volatility indicators lead price before major tops, they cannot establish timing, and reversals may occur several years later and while volatility keeps increasing.
In another blog about two weeks ago, I showed how the S&P 500 rose during the 1990s with VIX increasing and staying above its longer- term mean value of about 20. Here I show that even simple indicators, such as the ATR(14), suffice to measure volatility and can be leading indicators of major price reversals but, like VIX, cannot be used to establish even approximately timing:
The first indicator pane on the above daily chart of SPY since inception shows the ATR(14) indicator. It may be seen that although the value of this indicator started rising in around 1995, the top of the uptrend came after about four and a half years. The simultaneous rise in VIX along with the ATR(14) provides a confirmation that the 1990s trend occurred at higher volatility. On the contrary, this is not what happened before the 2007 top: although both the ATR(14) and VIX rose before the major top, it took less than a year from it to form.
The last observation is that the annualized standard deviation is a lagging indicator of price near major tops, as it may be seen from the third indicator pane, and when their timing is close to the start of the volatility rise. This is to be expected, since this is a smoothing indicator. This is also one reason that portfolio allocation based on such descriptive statistics has often failed to protected investors from sharp market declines. This is not the fault of statistics but a fault of models based on lagged parameters. Successful allocation needs active management to reduce risk before it manifests itself....MORE
