VIX Fails to Forecast S&P 500 Drop, Loses Followers
By Jeff Kearns and Michael Tsang
Dec. 22 (Bloomberg) -- Investors are starting to abandon volatility as a forecasting tool for stocks after one of the most-used measures of price swings failed to anticipate the biggest monthly decline in U.S. equities in 21 years.
The Chicago Board Options Exchange Volatility Index flashed “buy” signals for the Standard & Poor’s 500 Index during October’s 17 percent drop, the biggest since the stock market crashed in 1987. The so-called VIX also lost 44 percent since Nov. 20, a bearish signal, even as the S&P 500 rose 18 percent.
Money managers relied on the 18-year-old VIX as a guide for the S&P 500 because the gauge correctly predicted the equity index’s range 84 percent of the time and signaled the end of the bear market in 2002. Volatility, along with stock valuations and equity analysts, failed to signal the scope of declines in the worst year for stocks since 1931 as $1 trillion in credit losses spurred the first simultaneous recessions in the U.S., Europe and Japan since World War II.
“It used to be that an extreme one-week move in the VIX either up or down would give you predictive power, and now it’s just completely broken down,” said Stu Rosenthal, money manager at Volaris Volatility Management, a unit of Credit Suisse Group AG in New York that oversees $4 billion and handles volatility trading strategies for pension funds, hedge funds and wealthy individuals. “You have only 18 years of data, most of which was during one of the greatest bull markets in history.”
Calls and Puts
The VIX is calculated from what investors pay for options on the S&P 500. Because that reflects the cost of insuring equities with calls and puts, analysts developed models to estimate how far stocks are likely to fluctuate based on the level of concern implicit in option prices. Calls convey the right, without the obligation, to buy a security at a set price by a given date. Puts give investors the right to sell.
The S&P 500 traded beneath the lowest level predicted by the VIX from Sept. 29 to Oct. 30, the longest stretch ever, according to data compiled by Bloomberg. The benchmark index for U.S. equities also closed 10 percent or more below the lowest price implied by the index on 14 occasions during that period.
The breakdown was unprecedented for the VIX, which had indicated ranges for the S&P 500 that were off by more than 10 percent on just five occasions. Ben Londergan, Chicago-based chief executive officer of Group One Trading, says the gauge remains one of the best guides for investors.
‘The Weatherman’
“Saying the VIX isn’t worth looking at because it failed to predict October is like saying, ‘The weatherman said it was going to snow and it didn’t, so I’m going to stop looking at the forecast,’” said Londergan, whose firm buys and sells VIX options for traders as the contracts’ main market maker. “It’s not infallible, but it’s the best guess actual money is trading on.”
The S&P 500 declined 1 percent to 878.74 at 10:44 a.m. in New York, erasing last week’s advance, as a deteriorating outlook for corporate earnings offset expectations that government spending will revive the economy. The VIX fell 3.7 percent to 43.25.
The S&P 500 advanced or fell at least 1 percent on all but three trading days in October, the most since the crash of 1929. The swings made the VIX unreliable even as it set successive highs. In the 24 consecutive trading days that ended Oct. 30, the S&P 500 closed at a price lower than predicted by its so- called 30-day implied volatility.
‘Gotten Killed’
On Sept. 11, less than a week before New York-based Lehman Brothers Holdings Inc. went bankrupt and four days after the government takeovers of Washington-based Fannie Mae and McLean, Virginia-based Freddie Mac, the VIX closed at 24.39. That meant traders bet the S&P 500 wouldn’t fluctuate more than 24.39 percent on an annualized basis, or about 7 percent in the next 30 days, and implied a range for the index of 1,161.11 to 1,336.99.
One month later, on Oct. 10, the S&P 500 closed at 899.22, or a record 23 percent lower than what the VIX predicted.
“You would have gotten killed if you used it,” said Ryan Caldwell, who helps manage about $14 billion at Waddell & Reed Financial in Overland Park, Kansas. “Lately, it’s been tough to use it as a reliable gauge of market direction.”
While the VIX’s climb to 80.86, the highest close on record, coincided with the S&P 500’s 11-year low on Nov. 20, the volatility gauge has plunged since then, a bearish signal to investors who use it as contrarian indicator.
Arbitrage Index
The 44 percent drop since Nov. 20 through last week was the steepest in any period of 20 trading days for the VIX, suggesting investors should sell because options dealers are cutting the price of insurance too quickly. During that stretch, the S&P 500 climbed from 752.44 to 887.88, its biggest advance since the period ended Nov. 6, 2002, Bloomberg data show.
Investors who heeded the VIX this quarter suffered unprecedented losses, according to an index from New York-based Merrill Lynch & Co. that mimics returns of a strategy exploiting the difference between the predicted and actual magnitude of price swings.
The Merrill Lynch Equity Volatility Arbitrage Index plummeted 64 percent this quarter, wiping out more than a decade’s worth of gains, as price swings in the S&P 500 exceeded its implied volatility. From 1990 to 2007, the strategy produced an average return of 13 percent and never recorded a losing year.
Stock valuations and Wall Street analysts also gave “buy” signals prior to the October rout that turned out to be wrong.
Earnings Yield
The S&P 500’s earnings yield, calculated by dividing analysts’ overall profit forecast for companies in the index by its price, rose to 6.7 percent at the end of September, according to data compiled by Bloomberg. That was 76 percent above interest payments on 10-year U.S. Treasuries, the biggest gap in 20 years.
Analysts’ forecasts for profits at S&P 500 companies have proven too optimistic for five straight quarters, making price- to-earnings ratios that use estimated income unreliable. The number of “sell” ratings from Wall Street firms also declined to 5.72 percent of stocks tracked by analysts from 5.75 percent in January even as markets plunged, according to Bloomberg data.
Traders may have underestimated the likelihood that price swings would increase because the S&P 500 had suffered only one protracted bear market since 1990, said Volaris’s Rosenthal. That depressed option prices and skewed historical readings.
The VIX had never reached 50 before October. In the five times that the measure got within 2 points of that level --1997, twice in 1998, 2001 and 2002 -- it heralded gains in the S&P 500 that averaged 16 percent in the next three months.
‘Ring the Bell’
“If you looked at the VIX spike and then volatility coming back down, back then I thought ‘Ring the bell, maybe the worst is over,’” said Peter Sorrentino, who helps manage $16 billion at Huntington Asset Advisors Inc. in Cincinnati, including $127 million in options. “Not only did the VIX hit a new high, but the market also hit a new low. If you had used that as a signal to go all in, that was almost a career ender.”
For Fritz Meyer at Invesco Aim Advisors Inc., the biggest problem with relying on the VIX as a forecasting tool is that the index is still a product of predictions about the future.
“It’s just a bunch of guys in the options pit guessing,” said Meyer, the Denver-based senior market strategist at Invesco Aim, which oversees about $358 billion. “I don’t believe it.”
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