Perspective is easily lost if all you do is watch one slice of the market. The whole picture can alert you to a lot. Not just when to be concerned, but also when to look for opportunities.

If you focused solely on the Russell 2000 small cap index, the following picture probably sums up your experience and expectation. 

If all you've followed are large caps then the image below is probably your view, comparatively speaking. 

In case you haven't looked at either market this last year take a gander below. The S&P 500 ETF (left) and Russell 2000 ETF (right) are polar opposites. 

Back to perspective. One way I look at the whole market is by examining implied volatility. This gives a sense of fear by directly measuring expectations of those with money on the line.

Specifically, I combine all of the volatility indexes for the major US equity indexes, creating a composite of volatility/fear for the entire US Market. I can compare that composite VIX to the Wilshire Total Market Index, which measures the performance of all U.S. equity securities with readily available price data. 

So what does this fear composite look like? In the chart below, the Wilshire is in the top pane while the VIX composite is below.

Peaks in the VIX composite mostly match to bottoms in the Wilshire. Having a good estimate of what level volatility/fear is likely to have run its course would be very useful. I wrote an algo that does just that. You can read more about specifics here. 

The last real-time peak in fear, shown with red arrows, was detected on 10/10 and 10/13. Other peaks were detected in late-January and mid-April. Results of this approach on the VIX can be seen here. 

So what can we infer from this study? For starters, I would look for a peak if the VIX composite neared 120. This is the level that the algo would tag as a likely extreme. That would translate into a likely bottom in the market, being around the corner.

Can a bottom in the market happen without volatility reaching 120? Absolutely. Can volatility reach 120 and continue higher? Absolutely. Unexpected/underestimated world events, black swans and those other pesky unknown unknowns keep us on our toes. That said, the odds of a peak in volatility occurring if volatility reached that level and the market being higher 1 year later are 68%.

Just as useful, though, would be volatility settling back down below 67. Volatility remaining over that number would imply that traders are still expecting elevated levels of chop to continue.

Historic shift in volatility from small to large caps

There has been an abundance of discussion recently regarding the relative performance of large caps to that of small caps. Specifically, speculation has focused on the significance of the large cap outperformance for most of the past 6 months, as well as the small cap outperformance in just the past week. The dichotomy between the two groups, and its 180 degree shift last week, is perhaps best illustrated by today's Chart Of The Day.

It shows the ratio between the S&P 500 Volatility Index (VIX) and the Russell 2000 Small Cap Volatility Index (RVX). As recently as July, the ratio sat at almost 8-year lows -- not surprising considering both the record low volatility rally in the large caps this year and the struggles in the Russell 2000 since early in the year. Things can change quickly in this market, however. Last Wednesday, the VIX/RVX ratio spiked to a 6-year high. Furthermore, the reading was the 2nd highest on record, just behind October 22, 2008.

So what is the significance of this? For one, it illustrates the shifting risk focus from small caps to large caps. For those arguing that the small cap underperformance was a warning sign and would eventually be resolved by the large caps "catching down" to the small caps, this has been at least temporary validation. The spike in this ratio, and the reluctance of the small caps to sell off last week, was also likely a sign that the small cap selling had run its course, at least in the short-term.

Besides telling us what is happening, does the shift in this ratio give us any clues as to what is to come? Looking historically, we identified 4 other times since the origin of the RVX data (2006) when we saw a similar turnaround. None of the precedents were as extreme as the current example so we relaxed the parameters a bit. What we looked for were times when the VIX/RVX rapidly went from a 10-month low to a 10-month high (we chose 10 months because the obvious turn higher in 2007 came before we had 12 months of data on record and we wanted to include it). The 4 precedents came in February 2007, January 2010, March 2011 and August 2012.

A couple general takeaways from these prior events may be instructive to our present situation. First, besides the 2012 event, the others occurred into short-term weakness. Like our current case, large cap weakness was in some ways "catching down" to the lagging smaller cap area. The result, in those 3 instances, was a fairly significant bounce in the short to intermediate- term. That is the good news. The bad news is that all 4 of the precedents eventually led to a significant intermediate-term sell off. Those events included the flash crash, the 2011 bear market, the fall 2012 decline and, of course, the 2007 top.

We don't like to read too much into one indicator, and especially not an event with just 4 precedents. Furthermore, the current markets -- and markets in general -- do not lend themselves to the notion of certainty. However, if there is any guidance suggested by the development in the VIX/RVX ratio, it would likely be this: markets may be near a short-term low; however, a dramatic shift in its risk profile has occurred and stocks are likely at risk of a more serious, longer-term correction after a bounce materializes.

At a minimum, some seismic shift has occurred in this market as demonstrated by the historic shift in the ratio, even if we do not yet know what it is.

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