Over the past few weeks equity markets have been shaky—to say the least—owing to rising uncertainty over the global economy. Lately it seems as if every development in the European debt situation (some call it a crisis) leads to a massive market selloff, both here and abroad, as investors weigh the effects of global problems on the US economy and fear the worst for the future. The Chicago Board Options Exchange Volatility Index (Chicago Options: ^VIX) is often called the “fear index” because it measures the implied volatility of S&P 500 index options over the next 30-days. Its price corresponds to the expected change, so the recent VIX price of 32 indicates an anticipated annualized change of 32% in the S&P 500 price over the subsequent 30 days. In stable markets, the VIX typically stays in the 10–20 range; in very unstable markets, such as September 2008 – May 2009, when the price broke 80 on two occasions, we saw short-term averages in the 50s and 60s.
The VIX price is generally (and, as we will see, erroneously) accepted as a leading market indicator, meaning its movement precedes changes in stock prices. More specifically, a sharp rise in the VIX is thought to indicate an imminent drop in the market. This idea makes logical sense—heightened fear among investors triggers a rise in option premiums (implied volatility), which in turn triggers a stock market selloff. But after comparing VIX and S&P 500 prices over time, it is apparent that the VIX price has acted as a concurrent, or even lagging, indicator during higher levels of volatility, and no indicator at all during other times. If the VIX price were a leading indicator, the highest levels of volatility would indicate that the worst is soon to come; in reality, it indicates that the worst is already here, or in some cases, has already passed.
As you can see in Figure 1.1 below, the highest levels of the VIX usually coincide with cyclical lows in the S&P 500. The relationship is much more evident in declining markets, which makes sense, since the VIX price stays relatively consistent when the market is doing well. In Figure 1.2 I have included markers to show cyclical lows of the S&P 500 and the corresponding peaks in the VIX price. Perhaps even more helpful is Figure 1.3, which shows the S&P 500 vs. 1/VIX (the reciprocal of the VIX). You can see how the two measures move in tandem, since stock prices and volatility generally move inversely. This relationship is shown in greater detail in Figure 1.4, which tracks S&P 500 prices and 1/VIX from 2007 – 2009. Again, the relationship is stronger during this bear market, where volatility plays a greater role in investor decision-making.
One specific situation that helps illustrate this point, and has a number of parallels to the current situation in Greece, is Russia’s debt crisis of 1998 (Figure 1.5). The country was dealing with excessive inflation, and appeared susceptible to defaulting on its debt, much like Greece today. The ensuing panic (in the US) led to a -11.7% drop in the S&P 500 over a period of just 3 trading days, beginning on August 27, 1998. But as you can see from the graph, the VIX did not top out until approximately two weeks later, illustrating once again that the VIX typically coincides with or lags market movements. The fallout from the Russian debt crisis also led to a “double-bottom” the next month (shown by the green circles), where the market fell again soon after rebounding from a collapse. Once again, the VIX’s high came shortly after the market bottomed out for the second time.
It is no surprise that the volatility caused by the Flash Crash (May 6), combined with the situation in Europe, gave way to the S&P’s lowest close since February. But given what we have learned from the VIX (which hit 42.15, a 52-week high, on May 7), we know this increase in volatility was indicative of a current low, not an impending one. While this doesn’t mean that stocks can’t go somewhat lower before rebounding, perhaps accompanied by an even higher VIX, the May 7 peak in the VIX is useless in predicting whether or not this will happen.
The VIX price is generally (and, as we will see, erroneously) accepted as a leading market indicator, meaning its movement precedes changes in stock prices. More specifically, a sharp rise in the VIX is thought to indicate an imminent drop in the market. This idea makes logical sense—heightened fear among investors triggers a rise in option premiums (implied volatility), which in turn triggers a stock market selloff. But after comparing VIX and S&P 500 prices over time, it is apparent that the VIX price has acted as a concurrent, or even lagging, indicator during higher levels of volatility, and no indicator at all during other times. If the VIX price were a leading indicator, the highest levels of volatility would indicate that the worst is soon to come; in reality, it indicates that the worst is already here, or in some cases, has already passed.
As you can see in Figure 1.1 below, the highest levels of the VIX usually coincide with cyclical lows in the S&P 500. The relationship is much more evident in declining markets, which makes sense, since the VIX price stays relatively consistent when the market is doing well. In Figure 1.2 I have included markers to show cyclical lows of the S&P 500 and the corresponding peaks in the VIX price. Perhaps even more helpful is Figure 1.3, which shows the S&P 500 vs. 1/VIX (the reciprocal of the VIX). You can see how the two measures move in tandem, since stock prices and volatility generally move inversely. This relationship is shown in greater detail in Figure 1.4, which tracks S&P 500 prices and 1/VIX from 2007 – 2009. Again, the relationship is stronger during this bear market, where volatility plays a greater role in investor decision-making.
One specific situation that helps illustrate this point, and has a number of parallels to the current situation in Greece, is Russia’s debt crisis of 1998 (Figure 1.5). The country was dealing with excessive inflation, and appeared susceptible to defaulting on its debt, much like Greece today. The ensuing panic (in the US) led to a -11.7% drop in the S&P 500 over a period of just 3 trading days, beginning on August 27, 1998. But as you can see from the graph, the VIX did not top out until approximately two weeks later, illustrating once again that the VIX typically coincides with or lags market movements. The fallout from the Russian debt crisis also led to a “double-bottom” the next month (shown by the green circles), where the market fell again soon after rebounding from a collapse. Once again, the VIX’s high came shortly after the market bottomed out for the second time.
It is no surprise that the volatility caused by the Flash Crash (May 6), combined with the situation in Europe, gave way to the S&P’s lowest close since February. But given what we have learned from the VIX (which hit 42.15, a 52-week high, on May 7), we know this increase in volatility was indicative of a current low, not an impending one. While this doesn’t mean that stocks can’t go somewhat lower before rebounding, perhaps accompanied by an even higher VIX, the May 7 peak in the VIX is useless in predicting whether or not this will happen.
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