Nothing in life is to be feared, it is only to be understood.
Now is the time to understand more, so that we may fear less.
If you follow the financial news daily, you are constantly bombarded with headlines predicting the best of times or the worst of times. Case in point – The Fear Gauge! The Fear Gauge or CBOE’s Volatility Index (ticker symbol VIX) just hit a 23-year low or three week high or maybe as some suggest the fear gauge may not be that significant after all… So which is it?
What is the Fear Gauge?
I bet many of you are asking, so what exactly is the Fear Gauge? The following is a definition from Investopedia:
“VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking. It is calculated from both calls and puts, and is a widely used measure of market risk, often referred to as the "investor fear gauge."
That was helpful… right?
Perhaps Wikipedia can help us understand how to interpret the VIX (volatility index):
“Although the VIX is often called the "fear index", a high VIX, is not necessarily bearish for stocks. Instead, the VIX is a measure of market perceived volatility in either direction, including to the upside… Hence high VIX readings mean investors see significant risk that the market will move sharply, whether downward or upward. The highest VIX readings occur when investors anticipate that huge moves in either direction are likely. Only when investors perceive neither significant downside risk, nor significant upside potential will the VIX be low.”
If I were to read between the lines – The VIX measures how volatile investors think the market will be going forward; with a low VIX reading implying that investors don’t expect the market to move sharply in either direction. A high VIX reading implying investors expect the market to move sharply in either direction. This would imply that directional changes to the VIX might have some predictive correlation of the directional changes to the market.
The Relationship of the S&P 500 to the VIX
The chart and table below from the CBOE explores the relationship between the S&P 500 and VIX Index. Essentially, the chart and table show that directional changes to the VIX are about 80% accurate in predicting the direction of the S&P 500. For example, when the VIX is going down, the S&P 500 is going up 82.15% of the time.
Is the Fear Gauge Broken or is it the economy, stupid?
Today the VIX is hovering around all-time lows (see chart below), which has led many commentators to question the validity of the VIX or for the negative market pundits to call this the quiet before the storm – there is a “black swan” event looming that will take down the market.
The VIX doesn’t appear broken; rather like Bill Clinton once said… “It’s the economy, stupid”. In our view, the VIX is hovering near long-term lows because the economy is actually plodding along with good corporate earnings and private sector job growth. In addition, it is interesting to note that market fear hasn’t ticked up significantly with the technology profit taking over the past few days. To be clear, it has hit a 3-week high, but the VIX is still hovering around long-term lows. Investors don’t appear to be fleeing to the safety of bonds; rather we have seen a quiet rotation in the past few days, from technology stocks to financials and to dividend payers. It is too early to consider this rotation a trend; however, in our portfolios we have slowly added to our dividend payers while taking some profits from the technology sector.
At Kabarec Financial Advisors, Ltd., we will continue to monitor the VIX for directional changes that could truly indicate volatility ahead. In the meantime, I hope this has helped you understand more so you can fear less.