Should traders take wary after the VIX takes a journey to multi-year lows?
Is there a valid cause for alarm?
March 19, 2012
There's been a lot of discussion in the financial media lately about the sell-off in the CBOE Market Volatility Index (VIX), as can be witnessed in the excerpt below. On Tuesday, March 13, the Volatility Index touched an intraday low of 13.99, in territory not explored since June 2007. Plus, the "fear gauge" closed beneath 15 for the first time since April 29, 2011. And Friday, March 16, went as low as 13.66 to finally settle at 14.55.
“………..Add it up and the script for stocks looks fairly bullish. The economy is improving, the Fed will act if the recovery hits any potholes and many big banks have been given the green light to return value to shareholders.
But the one big risk contrarian investors keep pointing to is the slumping stock market fear gauge. The CBOE’s Volatility index, or VIX, has dropped 29% over the last week and yesterday flirted near a five-year low before finishing at 14.80.
VIX uses options pricing to measure the market’s expectations for future swings in the S&P 500. As the price to pay for portfolio protection has become extraordinarily cheap, the big fear is investors are becoming too complacent during this market rally.
“Anytime the VIX drops below 15 you have to start looking over your shoulder,” says Mr. Church of Addison Capital. “I would not be surprised if we start to see the market take a breather here.” -The Wall Street Journal, March 14, 2012
Given this significant downturn to multi-year lows, it is worthwhile for future investment security, to see whether traders should be alarmed about the Volatility Index's trip south of 15. Over the short term, it does seem that there's some valid cause for concern. The first table below looks at all instances where the Volatility Index breached 15 after trading above this level for 100 days, and provides the corresponding Standard & Poor's 500 Index (SPX) returns after each signal.
Over the next week, the SPX is positive only 37% of the time, and averages a loss of 0.2%. When you look 10 and 21 days out, however, the post-signal returns are nearly identical to the SPX's "anytime" returns since 1990 (second table below). So, while the short-term action could be a little bumpy, it is likely to expect the market to return to normal -- or at least, what passes for normal -- over the longer haul.
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