The VIX is often referred to as the markets fear gauge. It spiked last week and research suggests that’s a positive signal.
Last week the VIX spiked into the 40s in a declining market. That’s unusual. For much of last year the VIX traded below 15 and sustained spikes over 30 have historically been rare, occurring about annually in recent years, if at all. The VIX is often referred to as the market’s fear gauge. Technically, that’s not strictly true, what it actually measures is implied volatility on a basket of near-term S&P 500 stock options. Still the effect is similar, when there is a high degree of uncertainty in the market, that is often reflected in elevated option prices. This then shows up as elevated implied volatility. Basically, at times of market stress people want to pay up for the insurance that options can provide. The recent rapid decline in markets and associated global events are clearly a source of stress for many market participants.
Researchers have found that times of elevated fear can present buying opportunities. This is something traders have often known intuitively. The VIX is a reasonable proxy for fear in the markets. Researchers Alessandro Cipollini and Antonio Manzini have dug into the relationship over a decade ago, and it appears, broadly, to have held up since.
Their paper is here. The essence of the paper is that times of elevated volatility, both in absolute and relative terms, can lead to superior performance for the S&P 500 over the subsequent 3 months. This is based on an examination of the U.S. market from 1990 to 2007. Then the interesting implication is that last week the markets saw unusually elevated levels for the VIX, so the model suggests a buy signal for the next 3 months.
Nonetheless, some caveats are in order. Firstly, the sample from history may simply be too narrow to capture the full spectrum of potential outcomes. Yes, at times of elevated volatility returns have generally been good because things ultimately worked out well. However, maybe that outcome was not certain. Maybe investors really were taking risk that they were rewarded for, and the sample is not long enough to capture bad outcomes that were less likely, but dire.
Secondly, the VIX is generally predictive of volatility, so the risk and return relationship may hold up. Yes, returns may be higher over the coming months, but volatility may well be higher too. Just because the outcome may be positive, perhaps not all investors can stomach the journey to get there.
Finally, as a general sanity check, this is just one model. Often combining models and inputs can lead to less risky outcomes than betting on a single variable. You may only hear about the models that work, and not here about those that fail. If a lot of models are tested, the models that appear to work may be the result of luck rather than real insight. They may hold up less well in future than in the past.
Still at a time of elevated stress, it is notable that at least one indicator suggests things may prove to be better than many might anticipate. It is intuitive too. Perhaps the market has reached a level of panic that will not prove sustainable. Though the VIX remains a single indicator in a complex market.
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