Can the CBOE VIX Index help us find an investable market bottom? Sometimes called the “Fear Index”, the VIX actually measures the price of options-based insurance on near term moves in the S&P 500. And when traders fear a hurricane of volatility because storm clouds are already visible, they bid up the price of insuring portfolios. At some point the cost of insurance overstates the damage that will occur (because markets always overshoot), and you get a low for stocks.
That’s the idea anyway, so let’s look at the numbers:
- Since its start in 1990, the VIX has averaged a daily close of 19.1 with a standard deviation of 7.7 points.
- That should make 42.2 the buy signal, since it is 3 standard deviations from the mean (19.1 + 3x 7.7).
- As we noted in our Markets section of our full report, 5 standard deviation moves in the S&P are more common than a normal distribution would indicate. And since the VIX tracks near term actual volatility, it shares the fat tail phenomenon.
- Over the last 7,598 trading days since the VIX started in 1990, there have been 33 days when the VIX closed above 57.6 (its 5 standard deviation upper bound). Unsurprisingly, they were all in Q4 2008.
Bottom line: With a VIX Index close of 39.2 today, we’re still not at the 42.2 level that demarcates truly panicky territory based on a statistical analysis of the VIX. A few thoughts on that:
- The last notable VIX spike was in December 2018, when it closed at 36.1 on Christmas Eve. This was, in fact, a very investable low on the S&P 500 – the absolute bottom of December’s correction.
Even though we’re above those VIX levels now, however, the issues are different. Back then markets were spooked by Fed policy and, once Chair Powell announced he had changed his mind on January 4th 2019, stocks recovered. COVID-19 obviously does not have the same response function to the VIX that the Fed does.
- Similar to our point in Markets, the VIX can see 5 standard deviation variations from the mean when markets/worldwide economies are under structural duress. It is hard to see how COVID-19 can create 10% US unemployment or take US corporate earnings to zero, replicating the effects of the 2008 Financial Crisis, but it’s worth knowing these levels nonetheless.
As far as what all this means for finding an investable low:
- The first VIX level to watch is 42.2 (3 standard deviations), 8% higher than today’s close. That will signal a statistically unusual amount of market concern and could mark a near term low.
- The next one is 57.6 (5 standard deviations), 47% higher than today.
Importantly, history says the lows don’t happen when the VIX is this high. Remember: the 5-sigma VIX levels were in Q4 2008, and the S&P 500 did not bottom until March 2009. In fact, the Q4 2008 average S&P level was 895. If you held until the start of Q4 2009, you were up 18.1% but you had to transit the famous Devil’s Low of 666 on March 9th 2009 first.