Stop Wasting Energy On The VIX

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 |  Includes: SPY, TLT, VXX
by: Chris Ciovacco

Summary

The VIX Fear Index is arguably the most over-analyzed tool on Wall Street relative to its real-world predictive powers of where stocks are headed.

The common argument is when the VIX spikes, it is indicative of rising fear, and thus stocks typically drop when the VIX rises.

The VIX measures “expected volatility," which is quite a bit different than fear.

Can stocks go up when the VIX rises significantly from low levels? You can decide for yourself after reviewing a historical example.

Sounding The Low VIX Sirens For Stocks

If you follow the markets regularly, you have probably run across similar passages to the one shown below from a May 28, 2014, MarketWatch article:

As the VIX continues to sink closer to its historic low of 9.39, many commentators are now discussing the VIX as a "complacency index." As the VIX falls, it signals increasing levels of investor complacency. Because economist Hyman Minsky taught us that periods of high volatility follow periods of low volatility, many investors are beginning to worry that a "Minsky moment" could be lurking around the next corner that would send volatility higher, increase the risk premium for holding stocks and cause prices to sink.

GDP Aligns Nicely With The VIX Story

Having worked on Wall Street for more than 20 years, we can confidently state that you can always find a bearish narrative that sounds logical. The same can be said for a bullish narrative. Those reading from the bearish script got a nice rewrite Thursday in the form of revised gross domestic product (GDP) figures. From Bloomberg:

Less is more for the U.S. economy, which suffered its first contraction since 2011 last quarter. Gross domestic product fell at a 1 percent annualized rate, worse than the most pessimistic forecast in a Bloomberg survey of economists, revised Commerce Department figures showed today in Washington.

Low VIX Means Trouble For Stocks, Right?

The VIX (NYSEARCA:VXX) is currently close to a historic low. If that means historic complacency, then logic would tell us that when the VIX rises from very low levels, it must mean rising fear and bad times ahead for stocks… right? That logic often holds in the markets, meaning the VIX can be and is a useful tool for stock investors. However, the strength of a stock market indicator lies in its consistency. Can stocks (NYSEARCA:SPY) rise as the VIX rises from low levels? History not only says "yes," but it does so emphatically. The chart below shows a period beginning in late 1995 when the VIX started to rise from low levels. The VIX surged from 10.36 in 1995 all the way to 38.20 in late 1997, which is a major spike in the VIX. How did stocks perform over the same period? The S&P 500 gained 47%… yes, that is not a typo… stocks gained 47% during a period when the VIX more than tripled.

For those scoring at home, the 47% move in stocks began when the VIX showed "a high level of investor complacency" with a reading of 10.36. What was the recent 2014 low in the VIX? 11.36, which is quite similar to 10.36.

The VIX Is About Volatility, Not Fear

The moral of the story is there is nothing wrong with having the VIX in your stock market toolkit. However, the VIX needs to be used in the proper context to be more helpful to longer-term stock investors. From Yahoo Finance:

Today the VIX sits below 11.50 and stocks are slightly higher despite weak earnings and a widely expected, but still ugly, negative print in first quarter GDP. Rather than interpreting the market action as complacency traders are generally just accepting that the VIX is lower because the market is open for business. The thing is, the VIX never measured "fear." It measures expected volatility. If 11.5 seems like a low print that's only because you aren't putting it in the context of single-digit trailing volatility. The VIX is low for a reason and that reason is that stocks simply aren't going down in large enough gaps to justify paying much for insurance.

GDP and The Fed

The market's pricing mechanism has an almost infinite number of moving parts. One of the important parts is Fed policy. Thursday's weaker than expected read on the economy makes it easier for the Fed to stay committed to its low interest rate pledge. From The Wall Street Journal:

Investors shrugged off the GDP report, saying that it reiterated what is already known: the economy was sluggish in the first three months of 2014, in large part because of harsh winter weather. Traders said the latest GDP report does little to change the monetary-policy trajectory of the Federal Reserve, which is reducing its bond purchases but remains committed to keeping interest rates low for an extended period. "Volumes are beyond anemic," said Dave Rovelli, managing director of equity trading at Canaccord Genuity. "There's no reason to sell stocks if the Fed is going to be on your side." Gains were shallow but broad. Seven of the S&P 500's 10 sectors rose, with shares of companies in the consumer-staple and healthcare sectors leading the way.

Investment Implications - No Need To Anticipate

Have stocks corrected after the VIX hit low levels? Yes, we can find numerous historical cases where a rising VIX occurred during a weak period for equities. Regardless of what the VIX does, we know one thing with 100% certainty - the stock market cannot morph into a multiple-month correction or a bear market until the chart of the S&P 500 begins to break down. How vulnerable does the broader stock market look right now? Not very vulnerable.

This video clip explains why the charts above are helpful. Is using moving averages a perfect way to manage portfolio risk? No, but used in conjunction with other economic and technical inputs, it can help us stay aligned with the market's risk-reward profile.

The VIX Can Be Helpful

Before you begin writing nasty emails or tweets about the usefulness of the VIX, our market model uses the VIX, which means we agree that it can be helpful. The other key point is time frame. Shorter-term traders may have found countless relevant ways to use the VIX. We are investors, meaning it is important for us to understand what the VIX can and cannot do on a longer-term time horizon relative to the stock market.

Stocks And Bonds March In Unison

Typically during periods of economic fear bonds and stocks move in opposite directions. However, they moved in lock-step during several periods over the past few years. Therefore, it is not safe to assume rising bond prices means (a) the economy is on the ropes, nor (b) stocks are on the verge of a major correction.

As noted on May 25, our last chess move was to increase our exposure to stocks. Since then, the S&P 500 has added 18 points. The bond exposure (NYSEARCA:TLT) we still have has also been kind to us this week. With the market anticipating a weak GDP report, TLT is still up 1.35% this week even factoring in Thursday's session. We will continue with the "monitor and adjust" game plan rather than the more common "anticipate and hope" approach. For now, a portfolio of stocks and bonds with a heavier equity weight remains prudent.

Disclosure: I am long SPY, TLT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.