Reasons to Worry About the VIX

Posted by Brad McMillan, CFA, CAIA, MAI

Find me on:

This entry was posted on Jun 24, 2014 3:32:00 PM

and tagged Commentary, Economics Lessons

Leave a comment

VIXAlso known as the “fear index,” the VIX tends to stay low when investors are feeling confident and to spike when investors get scared. Technically, it reflects the volatility of the stock market—how much things bounce around—but on a practical level, it tends to mirror recent market performance.

Why should investors care?

When the VIX is low, returns over the next couple of years tend to be subpar. This is probably because, after a long run of success, investors get complacent—right about the time the market is due for a correction. You can see the negative correlation in the following chart, where spikes in volatility preceded lower returns. (Note 2008 in particular.)

VIX

Why does this matter right now? As you can see, changes in the VIX are at about the same levels as they were in 2007. The actual level, shown in the chart below, is also around the 2007 mark.

VIX

So, should we worry? Quite possibly—not necessarily because of the VIX itself, but because of what it represents. The VIX is largely coincident with the stock market, which makes it less useful as a leading indicator. While a spike in the VIX can indicate a sustained downturn, it doesn’t give you much advance warning.

A look at the Economic Policy Uncertainty Index

What we need is an indicator that’s highly correlated with the VIX, provides a signal several months ahead, and, ideally, is tied to fundamental economic factors. An interesting one I’ve found is the Economic Policy Uncertainty Index.

The index consists of three underlying components that measure uncertainty about economic policy based on:

  • Newspaper coverage of policy-related economic uncertainty
  • The number of federal tax code provisions set to expire in future years
  • Disagreement among economic forecasters

As Haver Analytics puts its, “The dispersion in three forecast variables, the consumer price index (CPI), purchase of goods and services by state and local governments, and purchases of goods and services by the federal government are used as proxies for uncertainty about monetary policy and about government purchases of goods and services at the federal level.”

Will the VIX climb alongside concerns about economic policy?

Looking at chart below, you can see that the Economic Policy Uncertainty Index jumped higher in 2006 and 2007, as well as in 2010 and 2011, preceding spikes in the VIX each time. Worryingly, we also see a very recent spike, taking us back to 2007 levels.

VIX

The VIX hasn’t responded yet, but if history is any guide, it’s not a bad bet that it will. Given the uncertainty around the federal government as elections approach, and the wide range of opinions on the economy, even at the Federal Reserve, the spike in the economic uncertainty index is reasonable. Add in geopolitical uncertainty, especially with respect to oil prices, and it makes even more sense.

I’ve said before that the market is priced to perfection, and the rising economic uncertainty index puts a quantitative figure on that. Based on past history, I wouldn’t be surprised to see uncertainty rise and stock market values suffer accordingly.

The problem, as always, is when. The chart above suggests the time might not be that far off.

Upcoming Appearances

Tune in to Bloomberg Radio's Bloomberg Businessweek on Friday, February 28, at 3:45 P.M. ET to hear Brad talk about the market. Stream the show live at https://www.bloombergradio.com/, listen through SiriusXM 119, or download Bloomberg's app, Bloomberg Radio+.

Tune into Yahoo Finance's The Final Round on Thursday, March 12, between 2:50 and 4:00 P.M. ET to hear Brad talk about the market. Exact interview time will be updated once confirmed. Watch at finance.yahoo.com

Subscribe via E-mail

New call-to-action
Crash-Test Investing
Commonwealth Independent Advisor

Hot Topics

Have a Question?

New Call-to-action

Conversations

Archives

see all

Subscribe

Disclosure

The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly into an index.

The MSCI EAFE Index (Europe, Australasia, Far East) is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.  

Third party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided at these websites. Information on such sites, including third party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation.

Member FINRASIPC

Please review our Terms of Use

Commonwealth Financial Network®