The stock market recently experienced the fastest market crash on record, so it's not a complete surprise that the CBOE Volatility Index (VIX) recently closed at its most extreme level. The March 16 VIX close of 82.69 barely topped the peak reached during the financial crisis in 2008. During the 1998 stock market drop and through the tech bust in the early 2000's, the VIX only got to the mid-40's. The current VIX didn't begin trading until 1993 but the CBOE has come up with estimates using other instruments dating back to 1986. Their evaluation suggests the VIX would have reached into the 140's in October of 1987! Recall, that was Black Monday, when the S&P 500 Index (SPX) fell more than 20% in a single day.
This week I'm looking at the heightened VIX and what it's telling us about the current stock market.
VIX and S&P 500 Volatility
For those unfamiliar with the VIX, it's calculated using short-term options on the S&P 500 Index. The more uncertainty there is in the market, the higher the option prices will be on the index, which increases the implied volatilities and the VIX. For this reason, the VIX is often referred to as the “Fear Gauge.” Essentially, the VIX is the market's expectation of the volatility over the next 30 trading days.
The chart below shows the VIX along with the 21-day (21 trading days is about 30 calendar days) historical volatility (HV) of the S&P 500 Index. During normal times, the VIX trades a bit higher than the stock market's actual volatility. The chart really highlights how crazy the current times are. Despite the VIX's spike to the highest level ever, it wasn't all that close to the actual volatility that the market experienced. The 21-day HV nearly hit triple-digits.
Here's a chart that shows how well the VIX has estimated stock market volatility. I subtracted the historical volatility of the market 21 for trading days (about 30 calendar days) to what the VIX reading was at the beginning of that period.
Most often, the VIX minus the realized volatility (orange line) is above zero, meaning implied volatilities typically overestimate actual volatility. It also suggests selling S&P 500 options will win more times than it loses. Those wins, however, are small relative to the massive losses that can be withstood during chaotic times.
Again, you can see in this chart how blindsided option traders were by the massive stock market downturn. On February 19, at the market highs, the VIX closed at 14.38. The volatility over the next 21 trading days was about 86%. So, the market's volatility was about 70 points higher than what the VIX was estimating. That's the lowest level on the chart.
Lasting High VIX Readings
The unprecedented spike in the VIX is the most obvious result of the market crash but the VIX has been high for some time now too. This is only the eighth time in history that the VIX has stayed above 30 for a month straight. The table below shows the prior instances with the last one occurring in 2011.
The recent instance shows the current 21-day volatility of the S&P 500 is still extremely high, registering in at 97%. The VIX, too, is the highest it has been after these occurrences. The most comparable time to this is the signal in October 2008 where the 21-day HV was 76% and the VIX was right around 55. The table shows the VIX underestimated the volatility ahead by a big margin. The last column tells us the volatility was 17.76 points higher than the 55% that the VIX was pricing into options.
Here's a table showing how the S&P 500 performed after each of those occurrences above. The returns generally look good the farther out you go. Three months after those signals, the index declined only one time. The bad news is the one time was that 2008 signal which was the most comparable time to the recent signal. In that instance, the market fell 15% over the next two weeks of trading and was down about that same amount six months late
The table below summarizes the S&P 500 returns after the instances noted above. This table shows typical index returns since 1998, the year of the first signal. It's only seven data points but stocks have struggled in the short-term with two-week returns averaging a 2.46% loss and only three positive returns out of seven. The three-month returns, however, are promising averaging a return over 5% with six of the seven returns positive.