With VIX This Low, What You Need to Know

by Daniel Putnam | August 17, 2012 8:35 am

Everyone seems to have an opinion on the VIX these days, but it wasn’t always this way. Once an obscure gauge used by options traders, the CBOE Volatility Index has exploded into prominence as a leading indicator of market performance.

Today, most individual investors could tell you the old saw, “When the VIX is high it’s time to buy; when the VIX is low, it’s time to go.” With the spot VIX having spent much of this week in the 14-15 range, it’s worth asking whether this adage has any truth to it.

A look at the evidence says it does, but with a bit of lag time and plenty of caveats.

During the past three years, the VIX has closed below 16 on seven different occasions. The table below shows that the first month after the initial sub-16 reading has brought solid returns for the market on average, as measured by the SPDR S&P 500 ETF (NYSEARCA:SPY[1]). However, the subsequent two-, three- and six-month periods have been characterized by returns that averaged out into the -2% to -3% range.

For perspective, consider that SPY has provided an average annual return of 14.85% during the three-year period measured.

First break below 16 1-MO 2-MO 3-MO 6-MO
3/12/12 1.32% -2.09% -2.96% n/a
6/30/11 -2.41% -7.79% -13.81% -3.80%
4/15/11 1.51% -3.81% 0.23% -6.23%
2/4/11 1.01% 2.04% 3.25% -7.45%
1/14/11 3.20% 0.58% 2.19% 2.21%
12/22/10 2.06% 4.87% 3.24% 3.25%
4/12/10 -1.91% -8.40% -9.35% -1.29%
Average 0.68% -2.09% -2.46% -2.22%

Now it’s time for the caveats, all of which dilute the importance of these averages.

First, it’s clear that the three-month numbers are thrown off by two significant outliers that bring down the average considerably.

Second, it’s notable that the two- and three-month periods, while negative on average, have combined to be a 50-50 shot on whether the market was up or down after the first break below 16.

Finally, the middle five dates on the chart were all part of an extended period during the first half of 2011 in which the VIX traded roughly sideways before ultimately exploding higher later in the year. As a result, there is some overlap in the time periods shown.

On the other hand, this table leaves out a near-miss that occurred in mid-2008, when the index closed at 16.30 on May 15 after trading as low as 16.19 the previous day. In this instance, the future returns were poor: -4.48%, -14.69%, -8.22%, and -39.38% in the next one, two, three and six months.

Two conclusions can be drawn from this modest data set:

1) Just because the VIX is low doesn’t necessarily mean the market can’t continue to move higher — a lesson illustrated vividly by various data points above and the entire 2004-2006 period. This is especially true now, with the possibility of central bank intervention continuing to loom.

2) Having said that, volatility is at a level that in recent years has indicated an above-average chance of negative future market returns. Based on this information, investors may be well-served by taking a more careful approach here.

The recent history also indicates that investors should avoid the temptation to chase the market higher if the large-cap indices break out above their April highs. This event, if it occurs, will be accompanied by much fanfare, as the Dow and S&P would both reach a four-year high, while the Nasdaq 100 would be at its highest level since 2001.

However, a VIX at 14-15 indicates low odds of an extended rally from here — breakout or not. In this sense, the current period may prove similar to mid-2011, when the market failed at several attempts to make new highs against a low VIX before ultimately breaking down in August.

spy With VIX This Low, What You Need to Know[2]

The bottom line: While the low VIX doesn’t mean a market downturn is a sure thing, there are enough negative data points to indicate that a measure of caution is warranted — especially in the wake of a three-month rally.

Endnotes:
  1. SPY: http://studio-5.financialcontent.com/investplace/quote?Symbol=SPY
  2. [Image]: http://investorplace.com/wp-content/uploads/2012/08/spy.gif

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