The VIX Says “Lighten Up”

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The VIX Says “Lighten Up”

US large caps have had a great run from their October 12th lows, with the S&P 500 up 12.6 percent through last Friday. That’s not quite as good as the June – August move of 17.4 percent from trough to peak, but it is still better than every other “bear market rally” this year.  Moreover, strength in US stocks has filtered over to international currency and equity markets. 

The current advance, much like the one over the summer, is based on the belief that the Federal Reserve will soon be ending its current rate hiking cycle.  While Chair Powell has remained resolutely hawkish since his Jackson Hole speech in August, other Fed officials have recently struck a more market-friendly tone.  Many seem to favor more modest rate increases over the near-term and perhaps even a pause early next year. 

The CBOE VIX Index is signaling that markets may have gotten ahead of themselves, however, and this “fear gauge” is flashing the same warning sign now as it did at the end of the June – August rally.  The chart below shows the S&P 500 (dark green line, left axis) and the CBOE VIX Index (dotted line, inverted right axis) over the last 12 months. 

We have marked the VIX’s 1-year “danger zone” of 20 – 24 with 2 horizontal dotted lines. Every time over the last 12 months when the VIX has gotten to these levels, the S&P 500 has topped out and started to decline again.  Such was the case in early January, early February, mid-April, early June, and mid-August. The VIX closed on Friday at 20.5, clearly in the deepest part of the danger zone and very close to the 19.7 reading that marked the August 16th highs for this summer’s rally.

Why has a 20-24 VIX been such a clear signal of an overbought, overconfident market all this year?  The answer lies in some simple but telling statistics:

  • The average daily close for the VIX going back to its creation in 1990 is 20.
  • The standard deviation of those readings is 8 points.  This simply means that the VIX usually runs in between 12 – 28, with only truly stressed markets showing a VIX of +36 (as was the case only once this year, on March 7th, just after Russian invasion of Ukraine). 
  • Given ongoing uncertainty about Federal Reserve monetary policy and its effect on the US/global economy, we should not be at “average” levels of expected stock market volatility.  Therefore, when the VIX gets to 20 we know markets have become too complacent. 
  • A VIX reading of 24 is exactly ½ a standard deviation (8 points) from the mean.

Bottom line: while December is usually a good month for US equities, the CBOE VIX Index is saying the current rally may be close to its end point.  All through 2022, US large caps have started to roll over when the VIX has gotten to 20-24.  This strongly suggests that it is time to consider lightening up on stock exposure.