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VIX Up, Market Down?by Bill Swerbenski, CFA, Director, Asset Allocation and Portfolio Analysis, Schwab Center for Financial ResearchNovember 4, 2008 What is the VIX Index? Often referred to as Wall Street's "fear index," the Chicago Board Options Exchange Volatility Index (VIX) indicates the expected future movement of the S&P 500 over the next 30 days.1 Without getting into the gory details, the VIX is derived from the implied volatility premiums observed in the S&P 500 index option market. The index gets its fabled nickname because the more volatile markets are expected to be, the more willing investors are to pay higher premiums for option protection. Thus, the higher the VIX goes, the more near-term risk is expected by the markets. VIX peaks and market crises often come in pairs During the current market crisis, the fear gauge has been hitting spectacular all-time highs—and these peaks have caused even the mainstream media to discuss this once-obscure index. Let's take a look at past market performance during periods when the VIX previously spiked to determine if we can learn anything from the historical behavior of the index. In "Historical VIX vs. S&P 500" below, we've included all of the available history for the VIX (which dates back to the beginning of 1990) and added labels that correspond to the major market crises over the years. Historical VIX vs. S&P 500  Data as of October 28, 2008. Source: FactSet. From the uncertainty of the first Gulf War to the trenches of the dot-com crash, the VIX often hits uncharacteristically high peaks during tough times like those we are experiencing with today's financial crisis. This relationship raises a question: How have markets reacted after past spikes in the VIX index? To find out, we examined the median total return performance of the S&P 500 for one month, one quarter, and one year before and after each day the VIX closed above a pre-set level. We chose to study various peak levels, ranging from 20–40, to avoid picking an arbitrary single threshold for the analysis, as well as to better understand the relationship between the severity of the peaks and the resulting follow-on performance after those peaks were experienced. Our results are shown in "VIX post-peak performance of the S&P 500" below. VIX post-peak performance of the S&P 500  The results depicted in this chart are based on research done using data from FactSet as of October 28, 2008. Market performance following large spikes in VIX In the past, the VIX was viewed as a contrarian indicator by many investment professionals—meaning that when the VIX was going up, the market would be more likely to go down (and vice versa). That behavior has been harder to pin down in recent years, and tends to be more relevant in the context of shorter-term trading strategies. With a longer-term view in mind, we examined the periods that followed extreme readings of the VIX index. We first observed that peaks above 25 on the VIX index typically, but not in every case, came after periods of significant loss in the S&P 500. Overall, the higher the peak, the more pronounced this phenomenon was. This trend confirms our initial suspicion that abnormally high spikes in the VIX are typically seen in distressed markets (although technically the VIX can rise on any increase in volatility, including those seen when markets surge upward). Next, we found that post-spike returns were most often higher than our naïve benchmarks—the median buy and hold returns of all rolling periods of equal duration—for VIX levels greater than 25. More importantly, we also saw that performance improved with higher peaks in the index as well as when the post-peak holding period was extended. The results shown in "VIX post-peak performance of the S&P 500" were quite dramatic. They show that post-peak returns outperformed in a very material way and suggest that extreme peaks in the fear index—like those we are seeing today—often manifest during periods of extreme pressure and may be indicative of the market capitulation and panic selling observed during the bottoming phase of previous historical crises. Given that, we see that now may not be the best time to start selling stocks, although it's hard to say how much we should really rely on the VIX for insight into future market moves. In isolation, the VIX is probably not a predictor of future market moves We must be careful not to draw unreasonable conclusions or to take these findings to mean we've hit the bottom of the current downturn. For starters, the history of the VIX is somewhat limited because it only goes back to 1990. (However, using the VOX, which is the predecessor to the VIX and which dates back to 1986, findings are similar.) Additionally, we must acknowledge that the markets have changed in material ways over the years, including the suspension of the up-tick rule for shorting and the proliferation of complex swaps and derivatives, just to name a few. It's also true that although the median post-peak returns were impressive overall, there were individual periods that did not fair so well—the main example being the periods immediately following the September 11 terrorist attacks. And, of course, there's the added complication of what specifically defines an "abnormal peak," although considering the VIX's current record-breaking levels, we believe it's safe to say that we are definitely experiencing one right now. What does this mean for investors? Is the VIX telling us we've actually hit bottom? Considering we're still facing a lot of uncertainty about the banking system and economy right now, it's hard to say. Given that, and remembering no one market indicator should be relied on in isolation, our findings do imply that, with respect to the VIX, this crisis is unfolding like many others have in the past: a significant market downturn and a wave of uncertainty that's feeding an impressive spike in volatility suggestive of the capitulation and panic selling often seen near the bottom of past crises. And although the VIX may not have topped out yet, it seems to us to be hinting that we may be reaching a climatic turning point in the current downturn. Does this mean you should run out and start loading up on equities? Certainly not. But considering the spectacular spike in volatility we're seeing and how far the markets have already come down, now is probably not the best time to wholesale exit the equity markets, either. Our suggestion is always to stick to the fundamentals of portfolio construction:
1. The Chicago Board Options Exchange SPX Volatility Index (VIX) reflects a market estimate of future volatility. VIX is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward-looking and is calculated from both calls and puts. Important Disclosures The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve. Indexes are unmanaged, do not incur management fees, costs, and expenses, and cannot be invested in directly. The S&P 500® index is an index of widely traded stocks. (1108-4018) Return to Top |
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