The most important technical indicator to keep an eye on today is the Volatility Index (VIX).

The VIX is commonly referred to as the stock market’s “fear gauge.” When stocks are rallying and investors are complacent, the VIX tends to fall. When stocks are falling and investors are fearful, the VIX tends to rise.

When the VIX reaches extreme levels – either extremely oversold or extremely overbought – the VIX can help point out potential reversal points in the market.

For the past four days, the VIX has closed above its upper Bollinger Band. That’s an extremely overbought condition – which often happens when we get a swift and severe decline in the stock market. When the VIX closes back inside its Bollinger Bands, it will trigger a short-term buy signal for the stock market.

Of course, I know there are plenty of reasons to be cautious on stocks in the intermediate and long term. Valuations are high, junk bonds are starting to break down, the transportation average has been lagging for several weeks, technology stocks are underperforming the broad market, etc.

But, in the short term, the market is setting up for one of those one- or two-day “wonder rallies” that crushes bearish traders who got too aggressive with short sales and convinces the bulls that everything is fine again.

We’ve had five such buy signals previously this year. Each one is circled on the following chart…

Here’s how they played out…

Each buy signal marked at least a short-term low in the S&P 500.

You’ll notice, though, that the strongest rallies off a VIX buy signal came when the S&P also closed below its lower Bollinger Band. Following those buy signals, the S&P rallied all the way to its upper Bollinger Band within just a couple of weeks.

If that happens this time – and there’s no guarantee that it will – the S&P could be trading above 2490 by the end of this month.

Of course, the VIX first has to close back inside its Bollinger Bands. That hasn’t happened yet. And the VIX could spike a lot higher before it comes back down and generates a buy signal. Once it does, though, the odds favor another solid move to the upside for stocks.

So, keep an eye on the VIX chart. Once the VIX closes back inside its Bollinger Bands, there’s an excellent chance this current decline phase is over – at least for the short term.

Best regards and good trading,

Jeff Clark

P.S. What do you think of the recent VIX action? Send me your thoughts, along with any other questions or comments, right here.