Investors continue to be faced with heightened political, geopolitical and macroeconomic uncertainty. Yet one market metric that is frequently used to gauge market volatility, the CBOE Volatility Index (ticker: VIX), seems to be showing this to be the quietest of times. Recently, the VIX closed at 9.77, its lowest level since December 1993, and also set a record for the number of consecutive days in which it has traded below 11. Many market commentators, however, have interpreted the current low VIX level as a danger signal that markets have become complacent and that rising risks are being ignored.
I thought I’d take a moment here to provide a bit of background on the VIX, some thoughts on what the measure’s recent developments might mean in market terms, and how an advisor or investor could use it in their investment process.
What is VIX?
The VIX is an aggregated mathematical restatement of a wide range of S&P 500 Index-listed option prices in index form. It is designed to indicate expectations of how much the equity market will move around in the next 30 days. The broadly referenced VIX figure (the recent 9.77 close) is the spot VIX level at the front end of the VIX curve, akin to an overnight rate in the U.S. yield curve.
Does a low VIX equate to a market pullback?
The VIX has tended to explode upwards in response to a sharp decline in the S&P 500 Index (SPX). But the corollary scenario of the market falling in response to low VIX levels has not tended to occur. Low VIX is not a causal factor for an SPX collapse, but an SPX collapse is a causal factor for high VIX.
Based on its history, it’s complete bunk to say that a low VIX level is a tried and true harbinger of bad markets to come. There have been prolonged periods of low VIX followed by very strong SPX returns (i.e. 1992–1996, 2003–2006, 2010–2011, 2012–2015, 2016–2017); if anything it’s more common to see the VIX rising before the market turns downwards (1997 before the 1998 SPX collapse; 2006 and early 2007 before the 2007 SPX reversal; shorter-term signals in 2010, 2011 and 2015). I see three prior cases with the VIX prevailing below 10 (see red horizontal lines under VIX in the chart below), and in each case the SPX was well into (about five years) recovery from a previous collapse: the 1987 crash, 2000 dot-com reversal and 2008–09 great financial crisis. Note that in all three situations the SPX rose a lot, but the VIX fell.
In a general sense, it wouldn’t be entirely wrong to see the VIX as the inverse of a trend: implied volatility often leans to the opposite of a trend in the underlying asset price (e.g. as asset prices go up, volatility goes down). The VIX falls as the SPX advances. As the SPX slips down slightly, the VIX bounces higher. When the SPX retreats significantly, the VIX gyrates wildly upwards. Note, however, that VIX moves aren’t helpfully predictive, nor overly timely. I am not aware of any market participant, strategist or academic who has proven that VIX moves are at all informative in advance. The VIX is very entertaining in the midst of an SPX shock, but it just is not a leading indicator. It has shown lots of false positives versus subsequent SPX moves.
Next, let’s look at whether the VIX is currently out of step with reality, indicating a complacent stupor among market participants and a fundamental miss on risk. If we look at the VIX in the context of broader cross-asset volatility, I wouldn’t say that the VIX is dangerously low. It is not out of step with MOVE (the U.S. Treasury yield implied volatility index), as both are at long-term lows. The same is true when the VIX is compared to GFSIRMKT, a measure of average cross-asset implied volatility. I would say, however, that seeing the VIX trade far below SPX-realized volatility for any decent period of time is dangerous and a sign of trouble. For context, SPX-realized volatility has stayed under 10% a fifth of the time since 1990, so perhaps a VIX level below 10 is not so crazy—so long as it is not out of step with realized volatility. Here’s a graph showing the historical and current context, and again it’s not something that stands out as a danger sign:
So if a low VIX doesn’t indicate complacency, what is it saying?
The essence of a low VIX is a stable macroeconomic backdrop:
- Positive synchronized global economic growth in line with capacity and with low momentum
- An absence of “too much” or “too little” inflation
- An absence of excessive leverage or credit creation (China and some U.S. non-financial company leverage notwithstanding)
- Very supportive financial conditions across the globe.
In fact, global macro volatility (measured as the standard deviation of quarterly real GDP growth rates) is at a post-1975 low. Central banks have also done everything in their power to prevent market instability following the financial crisis (i.e. ECB President Mario Draghi’s “whatever it takes”), including repeatedly talking the market off a ledge and supporting a buy-the-dip mentality. Here’s a great schematic of how this can play out in market terms:
How can I incorporate low VIX in my investment process?
- Don’t panic or assume impending disaster.
- Think through the root causes of a low volatility environment in a macro sense, and consider how long this state can last.
- Consider the current risk/return setup in capital markets as risk-asset supportive.
- Use the low VIX as a reminder, like tight credit spreads or elevated P/Es, that we are late into a market and economic cycle. But this does not mean an immediate turning point, especially in the face of continued easy monetary policy. Use the VIX, credit spreads and P/Es to increase your skepticism and vigilance for a market reversal, not as an excuse to bail out.
- I’ve never seen a tail wag a dog, and the VIX is a tail, not a dog. Focus on central bank balance sheet momentum, rate hikes, credit creation, economic growth, inflation, recession probability indicators, and leverage build-up as signs that the cycle could be turning.
- Expect a higher-volatility environment eventually, so don’t commit to any investment strategy that is highly or mainly dependent on current volatility levels. Low volatility has a limited shelf life in market terms—volatility is very mean reverting, and inevitably humans use low-volatility market cycles to lever up and overextend risk-taking to the point of unsustainability. This leads to asset price bubbles building, then popping, and higher volatility.
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