The Investor Fear Index Creeps Up Just In Time For Halloween
Market pundits are always tripping over themselves trying to determine the exact direction and extent of the market’s future movements. And as we approach Halloween, the fittingly named “investor fear index” is being scrutinized like never before. Do spikes in the VIX always spell future market declines? And are narrow movements in the VIX more a harbinger of the “treat” part of Halloween?
The Fear Gauge
Referred to as the “investor fear index” or just the “fear gauge,” the VIX is the ticker symbol for the Chicago Board Options Exchange Volatility Index, which shows the market's expected volatility.
First introduced 25 years ago, the VIX has evolved over the years and today it is a widely referenced measure of market risk – on a forward basis. That “forward basis” qualifier is important as it calculates future volatility and does not look backwards.
The VIX is calculated daily, similar to the S&P 500 Index. But whereas the S&P 500 Index is calculated based on the stock prices of all 505 companies (that’s not a typo, technically there are 505 companies in the S&P 500, but S&P 505 sounds odd), the VIX uses the price of options on the S&P 500 and estimates how volatile those options will be between the current date and the option’s expiration date.
Much like the individual stock prices of the 500 companies determine the value of the S&P 500 Index, the Chicago Board Options Exchange combines the prices of multiple options and derives an aggregate value of volatility – the VIX.
More than 30, Trick. Less than 20, Treat?
From an investor’s point of view, VIX values less than 20 are generally associated with less volatile and less stressful times in the markets.
On the other hand, VIX values greater than 30 are associated with a large amount of volatility, which increases investor fear – hence the reference to the “investor fear index.”
Said another way, when the VIX goes higher, it is considered a signal by many that investors are getting more worried about the market and taking appropriate action to protect their investments.
Fear in Percentage Terms
Although it’s usually not referred to in percentage terms, technically the VIX should be because it represents an expected range of movement of the S&P 500 Index at a “confidence level” of 68% – which is one standard deviation of the normal probability curve.
Here is an example: let’s say the VIX is quoted at 15. This represents an expected annualized change in the S&P 500 Index of plus or minus 15% – with a 68% probability of being true. In other words, the VIX is predicting with 68% probability that the market will move within a 30% range (plus or minus 15%).
Let’s say the VIX is quoted at 30. This represents an expected annualized change in the S&P 500 Index of 30% - up or down – with a 68% probability of being true.
See the difference? Which number elicits more fright for investors?
The Best and Worst Fears
Theoretically speaking, the VIX can reach any value from zero to infinity (it cannot be negative). In reality, the VIX has never been above 100 since 1990 and the highest value ever recorded was 80 during November 2008 – the peak of the financial crisis.
Although the market crash of October 1987 preceded the VIX, back-testing data shows that the VIX would have peaked at 150 on Black Monday (October 19, 1987).
The VIX hit an all-time low of 9.14 in November 2017, declining consistently throughout the remainder of that year, which is why technically 2017 was the least volatile year on record.
Since that time, the VIX has remained near historical lows and as of the middle of Q32018, it is hovering right around 18 (although it spiked to almost 25 on October 11, 2018).
So, Trick or Treat?
Mark Sebastian, former member of the Chicago Board Options Exchange and author of “The Options Traders Hedge Fund” noticed some interesting trends in 2018 and reported that on days where the VIX peaks, investors did not see the S&P bottom.
In fact, Sebastian reports that back in February 2018, the VIX peaked just before the S&P 500 bottomed, as shown in the following chart:
Sebastian further reports that the same thing happened in the summer of 2015, when the VIX surged to 40 exactly one day before the S&P 500 bottomed.
That’s why these charts might suggest – key word is suggest – that the market could retest October’s lows and go lower.
Market corrections are healthy and beneficial because they prevent bubbles from forming – which occur when stock prices get clearly out of line with the earnings potential of the underlying companies. We saw the consequence of that in the awful 2000-02 and 2008-09 market wipeouts, when some people lost half their wealth or more.
Should investors make short-term investment decisions based on the VIX? Most likely not, but they would be well-served by paying attention to its long-term trend.