The VIX Says Sell? Bull!

A lot of investors are getting fired up about the VIX lately, and I agree with very little of what they say.

What is the VIX? Some call it the "fear gauge" or the "panic index." In short, it measures implied market volatility based on option contracts linked to the S&P 500 Index. When panic strikes and investors expect volatility, the VIX rises. When investors are sanguine and expected volatility shrinks, the VIX falls.

That being the case, our inner contrarian often concludes that when the VIX is high, it's time to buy, and when it's low, it's time to run.

Right now, the VIX is as low as it's been in nearly two years, leading some to believe markets are doomed. "Traders are not forecasting much of anything ... a pretty good sign that we'll see quite a bit of something," writes one newsletter.

And maybe they're right. But using the VIX as a contrarian indicator is one those things that's beautiful in theory, but often useless in practice.

We need to address a few points before assuming that today's VIX means stocks are bound to fall:

  • Is the VIX low today, or is it just lower than the unparalleled highs of 2008 and 2009?
  • Is it possible for the VIX to be low, and yet for stocks to soar for years afterwards? 
  • Is there a statistical correlation between the VIX and the S&P 500? If not, why are we even having this discussion?

The respective answers are the latter, absolutely, and yes -- but none of that matters. Let's dive deeper.      

Who says it's low?
The VIX index is at 18 as I write. For those who claim this is low and a sign of investor complacency, it's fair to ask: compared with what?

Since the VIX began in 1990, the median reading is 18.8, so today's level is perfectly average. When you hear people gripe about how low the VIX is today, what they really mean is that it's lower than it was in 2008, when Wall Street was completely losing itself. Back then, the VIX shot above 80. But is this all that alarming? It's no different than recovering from hypothermia, and concluding that your sudden rise in body temperature means you're overheating. Widen your perspective, and the situation doesn't look so bad.

But let's assume it is low. Who cares?
It's true that you can find times when the VIX was low and stocks subsequently fell. But you can also find just as many periods when it was low (even by historical standards) and stocks went on to surge for several years. Have a look:





















Let's say that in 1991, you noticed the VIX had just fallen over 50% to about 16 (lower than today). The contrarian in you said "sell," concluding that investors were optimistic lunatics. Smart move? No. It was suicide. Markets quadrupled over the next nine years.

Or maybe you really thought you had the contrarian thing nailed down in December 1993, when the VIX hit its all-time low of 9.31. But you'd be wrong again -- the S&P more than tripled over the subsequent seven years. Companies like Microsoft (Nasdaq: MSFT  ) , Oracle (Nasdaq: ORCL  ) , and Yahoo! (Nasdaq: YHOO  ) made ordinary folks inordinately wealthy.

Oh, but you were entirely certain the VIX was foretelling doom in early 2004 after dropping more than 60% and hitting 14 (again, lower than today), right? No luck again: Stocks rose 35% over the following three years. So much for your contrarian indicator. 

S&P: The VIX just isn't that into you
The correlation coefficient between the VIX and the S&P 500 is pretty tight, but it doesn't predict much. If that jargon sounds foreign, congratulations: Your social life is probably more exciting than mine.

Here's all it means: Correlation coefficients slide on a scale from -1 to +1. A coefficient of +1 means two variables (like the VIX and S&P) are perfectly positively correlated; if the S&P rises, the VIX will rise by the same proportional amount. A coefficient of -1 implies a perfect negative correlation, meaning when VIX rises, the S&P should fall at the same proportionate rate. 

Going back to 1990, the average correlation coefficient between the VIX and the S&P 500 in any given year is a moderately negative -0.52. This implies that when one moves in a certain direction, there's a decent chance the other will move in the opposite direction -- just like the contrarian VIX advocates claim. This relationship is the foundation of their argument.   

Yet what's important isn't the correlation at a given point of time, but the relationship from one point looking forward, since future returns are all that matter to investors.

Lucky for us, stock research firm Birinyi Associates calculated S&P 500 returns 1,2,3, and 6 months after the VIX broke 20% below and 20% above its 50-day moving average.

By the contrarian theory, the VIX dropping 20% below its moving average should usher in low returns, and moving 20% above should bring strong returns. But that isn't the case:

VIX

1 Month

2 Months

3 Months

6 Months

20% Below 50-day Average

0.09%

(0.49%)

3.33%

5.84%

20% Above 50-day Average

1.25%

0.50%

0.95%

(4.51%)

Source: Birinyi Associates, Bloomberg.

Birinyi's conclusion really sums this all up. The VIX is a "measure of current volatility with little or no predictive or indicative value regarding the course of the market." In other words, it tells you what just happened, not what's going to happen in the future.

Moving on
None of this is to say stocks won't drop from here. But if they do, don't blame the VIX.

Focus instead on valuations. Plenty of investors have argued (fairly convincingly) that stocks are currently overvalued. But for every downbeat argument, you can find stocks like Procter & Gamble (NYSE: PG  ) , Johnson & Johnson (NYSE: JNJ  ) , and Altria (NYSE: MO  ) that are phenomenal companies and priced to do great in the coming years. And I guaranteed you their future success won't have anything to do with the VIX.

Be sure to check back every Tuesday and Friday for Morgan Housel's columns.

Fool contributor Morgan Housel owns shares of Procter & Gamble, Johnson & Johnson, and Altria. Microsoft is a Motley Fool Inside Value recommendation. Johnson & Johnson and Procter & Gamble are Motley Fool Income Investor recommendations. Motley Fool Options has recommended buying calls on Johnson & Johnson and a diagonal call position on Microsoft. The Fool owns shares of Oracle and Procter & Gamble, and has a disclosure policy.


Read/Post Comments (15) | Recommend This Article (52)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 26, 2010, at 11:18 AM, dibble905 wrote:

    Good article.

  • Report this Comment On March 26, 2010, at 12:02 PM, Bamafan68 wrote:

    Excellent article, Morgan. I like the empiric data you brought to back up your points.

  • Report this Comment On March 26, 2010, at 12:11 PM, anittanylionsfan wrote:

    This is a good article but pointing out the target audience would have made it excellent. If you're a fundamental trader - as most Fools are - then the VIX doesn't really mean much. But if you're a technical trader and subscribe to theories involving investor psychology then the VIX is an important indicator. Although you wouldn't ever set your trades up strictly on VIX behavior, you do become more cautious on your long trades when the VIX bumps up against a support level, as it did yesterday.

    The point being that if you only care strictly about fundamentals then you really need to ignore the pundits' chatter about the VIX. It's nearly meaningless, just as Morgan pointed out in a very well written article.

  • Report this Comment On March 26, 2010, at 12:13 PM, Darwood11 wrote:

    Thanks Morgan. As they say when looking into the tea leaves, one sees what one wants to see!

  • Report this Comment On March 26, 2010, at 12:14 PM, Darwood11 wrote:

    Thanks, Morgan.

    As they say when reading the tea leaves, one sees what one wants to see!

  • Report this Comment On March 26, 2010, at 12:51 PM, memoandstitch wrote:

    VIX alone isn't informative but if you use VIX in conjunction with the S&P, you will get nice returns. I'm telling you the magic formula: buy stock every time the VIX is high and S&P 500 is low.

    Those events occur in 1991, late 1998, 2003 and 2009. The best investing periods of the last two decades.

    What the VIX doesn't tell is when to sell.

  • Report this Comment On March 26, 2010, at 4:10 PM, retrobeast wrote:

    When someone rights an article like this saying to ignore VIX or other factors then I know it is time to get out of this market.

    The obama clown posse is keeping this market propped up with match sticks for the most part.

    Bad housing data and the market goes up at end of day?

    All these end of day runs are manipulation from the plunger team and nothing more.

    Get a clue people and cash in your profit before you wake up to a 500 down day.

  • Report this Comment On March 26, 2010, at 4:13 PM, retrobeast wrote:

    fool only prints the articles it wants to.

    what a shame.

    obama clown posse will fail.

  • Report this Comment On March 26, 2010, at 4:14 PM, retrobeast wrote:

    oh wait they did print it.

    new found respect for you.

    thanks

  • Report this Comment On March 27, 2010, at 12:30 AM, TMFFischer wrote:

    (I love the narrative shown in the comments from 4:10 to 4:14 pm. Kudos for following up with a compliment!)

    (It was a good article. Doesn't mean stocks won't drop, of course. At some point they will... (brilliant observation, I know.))

  • Report this Comment On March 27, 2010, at 12:25 PM, Charlie1368 wrote:

    I think that as an absolute indicator Morgan is right, the VIX is meaningless. Also for fundamental traders it is meaningless. however, as a relative indicator for technical traders it is very useful. Also, trying to be a reverse contrarian just puts you back with the herd, and then you definitely won't make any money. I think the VIX has its place, but to dismiss it as useless is an overstatement.

  • Report this Comment On March 28, 2010, at 9:30 AM, samdeva wrote:

    Great article and an eye opener. I got burned in both VXX and UNG and learned quite a bit since then.

  • Report this Comment On May 05, 2010, at 3:15 AM, Sidekicker101 wrote:

    Think you wrote your article a little early? ;)

  • Report this Comment On October 17, 2010, at 1:55 PM, jackorwell wrote:

    Now, many other countries like Canada, Japan and India are coming up with the products based on CBOE VIX (source: <a href="http://vix.co.in"http://vix.co.in</a>. I wonder if these products will be as successful as VXX or not?

  • Report this Comment On September 29, 2011, at 12:01 AM, rohitagarwal257 wrote:

    A similar research on India VIX also produced similar results (http://niftyvix.com/w/index.php/2011/09/10/timing-the-market...

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