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August 21, 2005
If the Contrarians Are at the Gate, They May Just Be Lost
By MARK HULBERT
SOME financial advisers who watch the VIX, a Chicago Board Options Exchange index that reflects traders' expectations of volatility in the stock market, have come to resemble cowboys patrolling their camp at night: They worry that trouble must be brewing when it becomes too quiet.
But however valuable that assumption may have been in the Wild West, it has not proved to be a profitable way of interpreting the VIX.
The C.B.O.E. created the VIX in 1993 to measure the expectations that options traders had about the volatility, or short-term price movements, of the stock market. The VIX is determined by a complex formula that is based on the assumption that, other things being equal, options will trade for higher prices when expected volatility rises.
The VIX currently stands at 13.42, which is lower than about 79 percent of the index's past readings. Its historical range extends from a low of 9.31 in December 1993, to a high of 45.74 in October 1998.
The exchange refers to the VIX as an "investor fear gauge," and the index quickly found a following among a group of market timers known as contrarians. They believe that the stock market rarely moves in the direction that the majority expects; therefore, they are bullish for the overall market when the VIX is high and indicating widespread investor fear. By the same token, they are bearish when, like today, the VIX is low and betraying investor complacency.
Researchers, however, have been able to find only partial historical support at best for this interpretation of the VIX. According to a recent Hulbert Financial Digest study, the stock market has indeed tended to turn in an above-average performance following very high VIX readings - just as contrarians say. But contrary to what contrarians believe, the stock market has also produced above-average returns following very low readings.
Indeed, the stock market has tended to turn in some of its worst months after VIX readings that are neither very high nor very low, but more or less in the middle of the pack. At the stock market's top in March 2000, for example, the VIX stood at 23.31, only moderately higher than its historical average of 19.7. During the 2000-2002 bear market, the average VIX level was 25.31, and never fell below 16.
Even though their bearish interpretation of low VIX readings turns out to be wrong, contrarians may still try to find comfort in the Hulbert Financial Digest finding that above-average market returns tend to follow high VIX readings. But it would be a mistake to credit the VIX for this, according to Samuel Eisenstadt, senior vice president and research director at Value Line Inc. in New York.
Mr. Eisenstadt argues that the root cause of the market's propensity to rise after high VIX readings has little to do with the index itself. Instead, he says, it is caused primarily by the market's tendency to reverse itself following sharp declines. Mr. Eisenstadt found that, once he controlled for those declines in his statistical tests, high VIX readings lost their apparent ability to forecast strong market action.
Does the VIX, nevertheless, have a role to play as a contrarian market-timing tool? Some market timers think it does, provided they focus on its recent trend rather than its actual level. These contrarians consider fast rises in the VIX to be bullish, on the theory that investors are quickly becoming scared. By the same token, rapid declines are taken to be bearish, since it must mean that investors are becoming smugly confident.
The Hulbert Financial Digest also failed to find support for this interpretation, however. On average, the stock market in the past has performed no differently after rapid rises in the VIX than it did after rapid falls.
Even if this alternate interpretation of the VIX had statistical validity, however, it would not support the bearish conclusion that many contrarians currently have been drawing. That's because the VIX has been locked in a fairly narrow range for several months now and therefore has neither risen nor fallen sharply.
The bottom line: There no doubt are many other things for investors to worry about, but a low VIX is not one of them.
Mark Hulbert is editor of The Hulbert Financial Digest, a service of MarketWatch. E-mail: strategy@nytimes.com.
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