Is Volatility Giving a Warning?

It has almost been a year since the Volatility Index (VIX) -aka the fear index- has closed below 20. The two years before, it was mostly around the low to mid-teens. The last time the VIX closed below 20 was February 21, 2020. Does this mean there’s no complacency anymore in the markets and only fear?

While the VIX is a real-time market index representing the market’s expectations for volatility over the coming 30 days, the lesser know VXV measures implied volatility three months out. One way to look at fear/greed is to use the VIX divided by the VXV: VIX/VXV ratio, as it filters out higher baseline readings liker now. See figure 1 below.

Figure 1. VIX/VXV daily ratio

High readings, i.e., spikes, coincide, clearly, with market bottoms as there is a lot of short-term “fear”; the VIX is very high. Since market bottoms form quickly, the ratio shows spike-highs. Conversely, when the readings become very low, i.e., traders and investors expect barely any volatility over the next 30 days, the market is -based on historical evidence since March 2009 low- close to a correction.

Low VIX/VXV readings and future market performance.

The current VIX/VXV ratio sits at 0.754. When the rate is about this low, vertical blue lines, returns for the S&P500 are often less than stellar. Namely, in 2012 the S&P500 lost 10-14% eventually. In 2015 the index stalled almost a year, adding a mere 3.5%, only to lose nearly 15%. Similarly, in 2016, albeit the pullback was shallow (-5%). In 2017 there were several<0.75 readings, and the market ignored those, gaining almost 20% since the first reading in August 2020 but losing at least 6% since the last<0.75 reading from December 2020. Besides, less low readings, like in 2018 and 2019, can still lead to 20% losses.

Thus, although the ratio is not precis in nailing the very top because as said tops take time, the current low readings warn that the S&P500 is closer to a significant, albeit interim, top, than a bottom. And as usual, “forewarned is forearmed.” IMHO, it does not mean to go full-on short or abandon all ships. It means one could, for example, raise stops, take partial profits, etc., which have never caused anyone any pain.