Wall Street’s 'fear gauge' just threw up a sign of complacency

The VIX index - a measure of implied volatility in the S&P 500 just dropped below 20 in a sign of improved sentiment and arguably complacency given the uncertainty at hand.

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Must know

  • The VIX index briefly fell below 20 for the first time since February but has closed back above
  • The VIX hit a record high this March when markets plummeted at the onset of the coronavirus pandemic. That came after it touched a record low in the slow burn uptrend of 2017.
  • The 20-level in the VIX has historically been used as a divide between high and low volatility environments
  • The VIX is normally negatively correlated with the S&P 500. However this year the VIX has been stubbornly high despite record high stocks
  • Conclusion: Dip below 20 signals either complacency before spike in volatility or new regime of lower vol markets in 2021

 

Chart

VIX index (year-to-date)

Having closed above 80 in March, the VIX has since been trading sideways in an ‘elevated’ trading range. 20 has been the support with around 40 as the resistance. It dropped below 20 for the first time since February on Friday.

 

Definition: The VIX index

The Cboe Volatility Index, or VIX, is a real-time market index representing the market's expectations for volatility over the coming 30 days. Investors use the VIX to measure the level of risk, fear, or stress in the market when making investment decisions.

- Investopedia

 

What’s happening?

What is setting up to be the best monthly rise for the Dow Jones since 1987 has also setup a collapse in the VIX index. The VIX is known as the ‘fear gauge’ because it tends to rise when investors are worried and selling stocks.

The two are inextricably linked because investors are buying stocks on the belief that they will move higher and in doing so are betting that there will be no high volatility sell-offs. Volatility tends be higher in down-moves than up-moves in price.

The renewed optimism and higher risk appetite has come alongside promising updates on covid-19 vaccines. The 3 late stage vaccines from Pfizer/BionTech, Moderna and AstraZeneca are now heading towards emergency approval for use by the general public. The reduction in political uncertainty since the US election has also been a factor.

 

What does this mean?

One of the maxims associated with the ‘fear gauge’ is that “when the VIX is low, look out below.” 20 is not low by historical standards but is low for 2020.

It can be seen in the chart below that the VIX spends long periods of time between 10 and 20 and will occasionally spike out to near 40, with this year and 2008 the notable high points.

 

The CBOE Volatility Index® has reached its highest level in history | BMO  Global Asset Management

 

The idea is that the market swings from periods of low to high volatility. When implied volatility gets very low- it becomes an extreme reading of sentiment that offers a contrarian signal to prepare for higher volatility and lower prices to come.

The problem is that the VIX, like most sentiment indicators is not useful for market timing. Just because the VIX dropped below 20 today doesn’t means the S&P 500 crashes tomorrow. Since there is still room within normal conditions for the VIX to fall further below 20, it could be that the VIX is implying a strong period for stocks with a lower volatility rise into 2021. However it is one signal to keep an eye alongside other sentiment and market timing tools.

If the VIX spends some considerable time under 20, then moves back above 20 I it could be a signal to lower risk levels in the market.

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