On May 10, 2017
Is the Volatility Index a Reliable Leading Indicator?
The low VIX (VIX-CBOE Volatility Index) reading is certainly grabbing headlines, but in our work, over the years, we believe the index has not shown to be a reliable leading indicator of equity market returns. Contrarians associate the low level of the VIX with investor complacency. VIX signal disciples believe that complacency is often followed by market corrections. But the empirical evidence does not support this theory with any consistency. Some like to point to the sub-10 level the VIX fell to back in late 2006 and early 2007 as the precursor to the market meltdown in 2008. But the fact is that the S&P 500 generated a 3.5% return in 2007, after the VIX bottomed, despite only 0.5% earnings growth that year. The VIX came off those low levels, and returned to average readings in late 2007 and early 2008 until Bear Sterns and Lehman Brothers fell in the summer of 2008; the VIX spiked afterward. But since the end of the financial crisis, and corresponding recession, the VIX has declined steadily, as stock prices appreciated.
Yesterday’s record-low VIX may reflect some complacency, for sure, but may also reflect investor attitudes toward a market that has appreciated by over 12% since the presidential election and is waiting for the next fiscal and monetary policy moves before taking a firm stance. It may also reflect investor unwillingness to bet against this market, on the fear that fiscal stimulus measures could wind their way through Congress, or earnings surprise to the upside, or both. For those who do want to hedge bullish bets, many have turned instead to sector, country, and strategy ETFs (Exchange-Traded Funds) that provide more concentrated exposure (long or short) than the broader VIX.
Additionally, liquidity and low options volumes may come into play when considering VIX pricing. The index is calculated based on the implied volatility of options prices and spreads. The options market, broadly defined, has experienced declining volumes over the last several years. Yesterday’s Wall Street Journal highlights the number of market makers who have exited the options business because of reduced liquidity, volatility, and economic opportunity. That contraction in liquidity may be having an adverse effect on the implied volatility embedded in options pricing, and thus the VIX price.
Other measures of equity market sentiment continue to tilt bullish, but are not extended. Flows into bond mutual funds and ETFs are positive, despite record low and climbing interest rates, suggesting investors are, in fact, pursuing protection and stability. This backdrop is supportive of low volatility, but not a major market correction, barring an unforeseen event, in our opinion.
Opinions in this piece are those of C.J. Lawrence and are not necessarily that of AAM.
This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.