The VIX, a widely watched gauge of investor sentiment,
measures volatility of Standard & Poor's 100 index
options. Expressed as a number, the VIX tends to spike
amid market panics. Ever-contrarian option traders view
a high VIX as a bullish indicator, and generally bet
against the fear infecting the Wall Street herd. (Hence
the old saying "When the VIX is high, it's time to buy.")
Conversely, when the VIX drops, pros believe that
investors are too complacent. The conventional wisdom on
Wall Street is that a low VIX means the stock market is
due for an implosion.
Not so fast. As a market-timing tool, does the VIX
actually predict the direction of stock prices? A new
report by Merrill Lynch's equity-derivatives strategist
Benjamin Bowler tried to determine whether the VIX historically has
been a good predictor of future equity market returns, by finding
cases where the VIX hit recent lows and tracking the market in
subsequent periods.
What Bowler found was surprising: The VIX is more reactive than
predictive. Changes in investor sentiment are priced into both equity
and options -- simultaneously. "I'm not convinced the options market
prices in risk not already priced in to the stock market," says
Bowler.
So can the VIX predict future returns? "The evidence is very poor,"
Bowler concludes. Since 1986, in 59% of cases when the VIX fell to a
relative one-year low, the S&P 500 actually rose during the following
one-month period. The same pattern holds for one week, as well as
three-month, six-month and 12-month returns. "While some might feel
that the VIX has been good at forecasting market turns -- the VIX had
fallen significantly prior to the market peaking in August of 2000 --
we find that since 1998, in only three out of five cases did the
market fall in the one-month period following the VIX hitting a
relative low."
So what can investors glean from watching the VIX, or volatility
measures such as the VXN (CBOE-Nasdaq volatility index) or the QQV
(the AMEX-Nasdaq volatility index)? Long term, the VIX should reflect
lower technology weightings in market indices. "The bubble in tech to
some degree translated into a bubble in volatility," Bowler adds.
But as a short-term tool, Larry McMillan of McMillan Analysis looks
at the VIX this way: "When volatility is low, one cannot know whether
the market will rise or fall -- only that it will be volatile."
There seems to be little disagreement over one fact: when volatility
has spiked, as it did in 1987, amid the Asian crisis, and after Sept.
11, the market rises. But when volatility is low, "the market does
not necessarily decline. It only does so about half the time,"
McMillan says.
Moreover, if volatility is low, investors get complacent, but they
don't necessarily think the market is going up. Rather, they think
it's going nowhere. Taken to its logical conclusion, a low volatility
reading actually signals the public does not expect the market to
move much in the near future at all.
Hopefully, this helps debunk the Wall Street myth that low volatility
always precedes falling prices. Sometimes it does (especially in the
last two years, where huge moves occurred), but most often it does
not. Low volatility does precede a volatile market.
By extension, in low volatility periods, investors who traditionally
run out and buy put options as insurance against a decline should
consider buying straddles, which profit from big price swings in
either direction. |
