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For those of you who don't know, the VIX is The Chicago Board Options Exchange Volatility Index. It measures the cost of using options as insurance against declines. As equity markets have been rising over the last few weeks/months analysts have been increasingly talking about the VIX as a hedge. In theory this makes sense, but in practice this strategy is flawed.

The trouble is that the VIX is supposed to be a prospective look account of upcoming volatility, but it is based solely on retrospective data. So every time a macro decision (monetary or fiscal) is made and the market reacts, the VIX drops before those decisions are even implemented and markets are substantively impacted. A prime example of this phenomenon is the VIX response to FOMC meetings. When the Fed is contemplating a policy change, the VIX rises ahead of the meeting only to drop rapidly once a policy change (or no change) is announced. This drop is a result of diminished policy uncertainty creating less volatility. The trouble is that this VIX reaction does not account for the possible market volatility as a result of implementing policy change or market turmoil from a surprising lack of policy change.

(click to enlarge)If we look at a two year chart of the VIX (chart from Yahoo Finance) if is clear that the VIX does spike ahead of major Fed decisions and drop immediately after. In September of 2011 the VIX was extremely high and almost immediately dropped when the Fed announced Operation Twist. Similarly, the VIX climbed ahead of the announced expiration of Twist in June of 2012 only to rapidly drop again when the Fed announced that Twist would be extended through year-end. Even with Twist ongoing, the VIX crept upward as the Fed contemplated a third round of Quantitative Easing in September of 2012; when QE3 was announced, the VIX dropped again. Perhaps the starkest VIX reaction in the last two years comes from the fiscal cliff when the VIX rose rapidly ahead of year-end before plummeting when a deal was reached. However, as we now know, this deal resolved little and kicked most tough decisions further down the road.

So, the VIX tells us very little about upcoming market volatility and a lot more about confidence or lack thereof in the current market and current macro policies. As with almost any aspect of investing, this confidence in the market is highly susceptible to psychological manipulation. In the last month (see Yahoo Finance chart below) we saw the VIX spike ahead of the "Sequester" only to have it plummet again despite a complete lack of resolution to fiscal policy reform. In other words, people were scared about the effect of the sequester before it happened, but as it is slowing going into place, thereby harming our economy, market actors irrationally fear it less.

(click to enlarge)Essentially, the data demonstrates that the VIX is a representation of flawed market psychology, not a prospective tool for examining future volatility or hedging against it. At the time of this writing, the VIX is near a 6-year low despite the fact that U.S. fiscal policy is a mess, the European crisis remains unresolved, Britain appears to be in a triple-dip recession, Japan is actively devaluing its currency, and China is undergoing a once-in-a-decade leadership change. All of these macro forces should be screaming increased market volatility, but with companies showing strong P/E ratios and investors clamoring into stocks, the VIX remains low.

At best, investors should treat the VIX as a measure of upcoming market uncertainty, not a true measure of volatility. As a measure of uncertainty, investors should be able to find excellent entry points into VIX-tied funds ahead of monetary and fiscal policy events that are sure to increase market uncertainty; the trick is exiting before the market decides that these policy circumstances have been resolved and the VIX drops.

Source: The VIX As A Measure Of Uncertainty, Not Volatility