By Alan Farley, Special to RealMoney.com
The multiyear rally turned most investors into bull market geniuses by the end of the 1990s. This twisted logic drove that secular advance, and the situation fostered a reckless attitude that led to the destruction of many retirement accounts.
If you need a quick primer on the line of thinking spawned by bull market genius, here goes. Price-to-earnings ratios don't matter anymore, because this is the New Age of Capitalism. Buy the dip whenever a stock falls, because it will always come back and move higher. The good times will last until 2015, when baby boomers crack open their fabulous 401(k)s.
No doubt we've learned many hard lessons over the past three years. In the process, a new critter has started to grow from the ashes of our diminished wealth. This dangerous animal is just as confident about the future as the bull market geniuses of the past were.
But these gloomy whiz kids can't see anything but darkness at the end of the tunnel. Bear market genius is now having its day on Wall Street. This inverted mindset finds the negative view in each uptick and sees no outcome except oblivion.
But this flawed assessment will fail in the same way its bullish twin did. And the time has come to challenge one of the pillars of its negative logic.
Bear market geniuses couldn't spell VIX two years ago, but it's now at the center of their gloomy predictions. They're hanging their hats on a popular strategy that calls for a selloff whenever the VIX drops more than 10% below its short-term moving average.
We hit that sell signal last week, so the bears are waiting for the market to take a nose dive. The problem is that the indicator can respond to longer-term cycles as well as shorter-term ones. As we'll see in a moment, there's solid evidence that broader-scale movement is now taking control.
There are many ways the VIX can respond to short-term sell signals while equities move higher over time. The most common scenario would be a series of small reversals that shakes out weak hands but keeps prices intact on the stocks and indices. This process would also bring down short-term VIX averages and let the indicator continue its spiral toward lower levels.
Bears point to declining volatility as a sign that the rally off the October lows has run its course. But they're blind to seasonal cycles that carry the indictor lower into the summer months year after year. They've become so jaded that every positive sign draws a negative conclusion. But the day is coming when it'll be a mistake to trade against good news.
The VIX reached its annual low during the summer months in four of the last five years. What about that aberrant reading in March 2002? I recall a shocking event that took place about six months before this reading: Sept. 11, 2001, likely shifted the natural volatility cycles for that year alone.
