In This Market, Volatility Gauges Are Just a Sideshow

Here’s an interesting article from Barron’s Online today: The Best Way to Use the VIX

Bill Luby, editor of the blog, VIX and More, said, “A classic misuse of the VIX is as a market timing signal. The VIX is generally negatively correlated with the broad market indices, but this correlation waxes and wanes.”

This throws conventional wisdom a curveball right away.

He continued, “Further, investors tend to believe that absolute numbers for the VIX are sacrosanct, so that a VIX of 30 or 50 or 70 starts to take on a special significance [see Chart 1]. For the most part, my research and experience suggests that absolute VIX levels are much less meaningful than the current level of the VIX in relation to recent levels.”

This is something I’ve outlined more than a few times:

• Volatility Spikes Higher (But Not High Enough)
• VIX’s Distance From Moving Average Is Bullish
• The Volatility Index: It’s All Relative
• The Heartbeat of the Stock Market Goes Thump

Although looking at volatility through the prism of relative performance helps us to understand it better, it can still at times be elusive. This chapter of market history is just one of those times. What we have seen recently is such an outlier that even when we look at relative volatility, rather than absolute volatility, we still see an aberration worthy of extreme value theory. With one exception.

I looked at the CBOE NASDAQ volatility index (VXN) and compared it to its simple 150 day moving average. Here is where we are now relative to where we’ve been before:

In 1998, the distance of the VXN from its 150 day moving average peaked on early October, just as the market made the final low. In 2000, it peaked in mid April but the market was far from a lasting low. And that brings us to 2008 when the relative VXN peaked in late October.

My hunch is that during “normal” markets, the VIX and VXN provide great signals. But removed from a stair stepping bull market, things can easily become extreme and lose meaning. What we saw in early 2000 was the pricking of an asset bubble and its consequences. What we are seeing this year is the pricking of a credit bubble and its consequences. Until we once again see “normal” markets, the volatility gauges will be an interesting sideshow.

Comments

[Kingsley An...:]

Babak,
I tend to agree. Similar to oscillators, things can get oversold/overbought and stay there for some time. Most definitely, the VIX should not be used by itself as a market timing tool.

2008 Dec 26 07:25 AM