Is the Volatility Adjusted S&P 500 Index at Fair Value?

March will go down as one of the most difficult months in history. Earlier in the month, investors were wonder whether the death of Kobe Bryant would be a memory that would linger for months. This was quickly replaced by the unset of the coronavirus and one of the worst selloffs in history. The S&P 500 index dropped approximately 35% from peak to trough but was the drop adjusted for volatility, a time when fear was palpable.

The S&P 500 ran up to all-time highs on February 19 and then was hit by the coronavirus train. Implied volatility as reflected by the VIX volatility index, was hovering near 12-month lows, which put the ratio between the S&P 500 index and the VIX volatility index at all-time highs. Fast forward 6-weeks and the ratio between the S&P 500 index and the VIX has dropped from 250 to 48.4, a collapse of more than 80%.

With this sharp decline as a backdrop, the question is whether current levels reflect a ratio that would lead to a continued rebound in stock prices. The VIX has moderated slightly at the S&P 500 rose, but the current ratio of 48, is well above the levels seen in 2002 (during a recession) or in 2009 (during the great recession). The ratio even dropped further during the European debt crisis. The best way to analyze whether the drop in the ratio was equivalent to other declines in the ratio is to look at the peak to trough decline in the ratio.

In 2002 the ratio dropped 80%, and in 2009 the ratio dropped 89%. In 2011 during the European debt crisis the ratio dropped by 71%. This puts the decline in the ratio of 81% in the middle of the range and likely a place that you could consider the ratio fair value relative to historical selloffs. This likely means that the S&P 500 has put in a bottom, and while it will likely revisit the lows made earlier in March, it will not likely surpass that level by a significant amount.