VIXed Out

CXO Advisory studies the relationship between the VIX and future stock market returns.

Experts and pundits often cite a very high (low) Chicago Board Options Exchange (CBOE) Volatility Index (VIX) as an indication of investor panic (complacency), and therefore of a pending U.S. stock market advance (decline). Is this conventional wisdom regarding VIX as a market reversal sentiment indicator accurate? To check, we relate the level of VIX to future stock market returns (using the S&P 500 index to represent the overall stock market) over horizons of 10, 21, 63 and 252 trading days. Because VIX tends to “stick” in high and low regimes over extended periods, we also relate the level of VIX relative to its 63-trading day moving average to future stock market returns.

That “regime” concept gets it spot on. We lived in a high VIX world in the late 90’s through about 2001, followed by a low VIX world until about February 2007. And right now we’re back to high again, such that if we see 40 again, it’s almost tantamount to about a 20 or 15 a few years ago. So if you’re going to use the VIX, it would seem that you can throw absolute numbers into the hopper.

So what do they find? Well, first, how about an absolute VIX.

Over the entire sample period, the Pearson correlation between VIX and S&P 500 index returns over the next 10 (21 / 63 / 252) trading days is 0.02 (0.04 / 0.09 / -0.03). These very low correlations suggest no relationship between the level of VIX and future stock market returns.

I’m sure Dennis Kneale will disagree.

What about “relative” VIX? They compare it to it’s rolling 63 day MA and find.

The chart suggests that a relatively low VIX is slightly bullish across all return horizons. It also suggest that a relatively high VIX is somewhat bearish over the near term and bullish for the intermediate and long terms.

OK, we’re getting somewhere. But almost exactly opposite of what we think. It’s almost as if……the VIX is a coincidental indicator that kind of confirms something we may already know.

But wait, there’s even less than meets the eye. As CXO accurately points out, high and low readings tend to cluster and reaffirm themselves.

So they account for that too, and find.

Results are mixed. Over the short and intermediate terms, stock market returns after extreme VIX conditions are mostly close to the norm. Over the long term, returns after all the relatively extreme VIX conditions underperform the norm. However, subsample sizes are small, especially for long-term returns, so these conclusions are not reliable. Just a few new instances could substantially alter average returns.

Moreover, there are not enough trading opportunities to make a strategy based solely on the selected thresholds for VIX signals interesting.

Bottom line is it all kind of makes sense. I find the most value in the VIX from divergences to the expectation. Is it seeing something we don’t? Is it underpricing risk, as it did all through October when realized volatility soared ahead of options volatility? Is it too high or too low relative to actual stock volatility?

It’s subjective, but so be it, there’s no magic bullet here. Right now I subjectively find volatility close to correct. Realized volatility has tamped down a bit, we just drift now. But the market’s incredibly ugly, and you’ll never get a big options selloff when that’s going on.

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