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  • The commentary that the "VIX as not accurately reflecting fear" is misleading.
  • The VIX should only be used for what it was designed, and is best used with other indicators to forecast danger.
  • The VIX is accurately reflecting sentiment in the face of geopolitical upheaval and Federal reserve policies.

The map of the Middle East is about to be redrawn in the midst of the worst sectarian fighting in Iraq in a decade. The terrorist group ISIL, threatens to wipe out any socio-political gains the US made in region and disrupt oil supplies coming from OPEC's second largest producer. Rising oil prices, which impact virtually every aspect of global commerce, will surely threaten an already fragile economic recovery in the United States.

… and the S&P500 (NYSEARCA:SPY) just hit another record last week.

Heard this story before? This is the exact pattern that we have observed going back to the Fiscal Cliff drama of 2012. In fact, geopolitical flare-ups have created some great trading opportunities for those who were brave enough to look past the headlines.

To illustrate this, I have compiled a list of some of the major negative market-moving in the past three years and the market's subsequent recovery. The figure below also highlights these events against a seven-year chart of the CBOE VIX index (VIX).

(click to enlarge)

(click to enlarge)

With the exception of the US debt downgrade and the subsequent European sovereign debt crisis the summer and fall of 2011, most of the hiccups in the market were relatively short-lived. In addition, the percentage declines and the time to recover are both getting shorter.

Mind you, none of the issues in the table above would be considered "resolved" today by any means - European sovereign debt, Ukraine, Argentina potentially defaulting on debt, and certainly not Iraq. Once these issues settle into some kind of "stalemate" or the immediate threat recedes from the headlines, bullish sentiment returns very quickly.

The stock market's inexorable rise has spawned a lot of attention on the VIX, commonly referred to as the "fear gauge." Currently trading near historic lows at around 10, the VIX is often cited in commentary and speeches about widespread investor complacency. Some have even implied that the VIX has become irrelevant or "broken" because it is failing to capture the real level of risk that has to be "out there" given the headlines.

I will argue that the VIX is doing exactly what it's supposed to do. In fact, rather than indicating complacency, its recent behavior is giving you the correct near-term perspective on the supposed tumult around us. It's the arguments to the contrary that are erroneous.

Faulty Logic

Let's first address the faulty logic in a current line of thinking, which goes something like this: "Periods of low volatility often precede a crisis. We are in a period of low-volatility. Therefore, a crisis is coming soon. The market is bullish and ignoring this future crisis. Hence we are complacent". On the surface, the argument is compelling but ignores a critical fact: low-volatility is not the trigger for geopolitical tensions or fiscal / financial instability. Governments, regulators, banks, and terrorists are the culprit.

There is some credence to the reasoning advocated by Hyman Minksy and others that purports stable economic conditions lead to overconfident and irresponsible behavior. If not checked by the appropriate authorities, this will inevitably lead to some financial calamity until a new equilibrium is restored.

However, faulting the VIX for not detecting these longer-term negative trends is akin to calling your thermometer unreliable because it didn't forecast climate change.

Now would be a good time for a reminder of what the VIX really does represent: the market's expectations of the stock market volatility in the next 30 days. As investors trade near-term puts and calls on the S&P500, they affect the price of these options and their implied volatilities. Therefore, these investors indirectly set the price of the VIX, which uses these option prices as inputs.

The graphic below is a simplified visual representation of the VIX that I created when I was first trying to understand this index. This figure shows that we can construct a "synthetic option" from near term and next near term option contracts on the S&P500. VIX represents the implied volatility of this synthetic option that is expiring 30 days (to the minute) of the current time.

(click to enlarge)

The first key point that should be noted is that the VIX "lookout period" is only a month. It should not be treated as anything more than that.

It is well-known that the VIX tends to spike during periods when markets experience sudden declines and "fear is in the air." There are several reasons for this, including the simple mechanics of supply and demand for options. For example, investors will rush to pay more for put option protection during rapid declines, hence indirectly raising the VIX. When sentiment is bullish, people tend to "let it ride." That is, you don't hear investors rushing to sell calls against their long positions or rushing to buy put protection. This tends to keep the VIX low as the S&P500 rises.

Interestingly, neither the inventor of the VIX (Professor Robert Whaley) nor its sponsor - CBOE - have shied away from using the term "fear index" to describe the VIX. However, the financial press has misused this to imply that the VIX can forecast market declines rather than what it really does: react to them.

The VIX and Other Indicators: Better Together

Most serious market watchers use the VIX in combination with other technical indicators to measure the severity of any pullback. This is especially true for periods of elevated volatility that presage longer-term market declines because of deeper fiscal issues.

A great example of this is to observe what happened in 2011. The S&P 500 was up over 7% from the beginning of the year through April. But this bullish sentiment would run headlong into political and fiscal headwinds in the US and abroad. The debt ceiling drama, followed by the US credit downgrade, followed by a reprise of the European sovereign debt crisis in Greece, Italy, and Spain changed things rapidly and sent the market spiraling downward.

How good was the VIX in predicting this a month earlier? Not very good. From May through July 2011, the VIX fluctuated between 14 and 17; and watching its behavior you could not tell that calamity was around the corner. In July, there was nothing in the VIX chart that would have indicated that it would spike to 48.

Indeed, those who advocate the reductionist argument (i.e., "high volatility always follows low volatility") were saying, "I told you so!" But a more constructive approach to determine if VIX spikes are really signaling long-term danger is to combine them with other technical indicators.

This is illustrated in the figure below. In August 2011 the S&P500 quickly fell below some key technical levels. More importantly, the 50-day SMA crossed below the 200-day SMA, a technical pattern commonly referred to as the "death cross."

(click to enlarge)

In contrast, compare the market reaction to crises in 2014. The 50-day SMA doesn't threaten to cross the 200-day at all, and both averages rising along with the S&P 500. And you have to take VIX spikes in 2014 with a grain of salt. The "spikes" are generally a couple of VIX points (i.e., from 11 to 13 or 14). The index is still well below its long-term mean, which is approximately 20.

Another very useful chart to examine during periods when the VIX is rising is the VIX futures term structure. While details of VIX futures are beyond the scope of the article, it's worth mentioning that a "normal" VIX term structure is in contango. For brief periods in the summer of 2011, a part of this curve became inverted and went in backwardation. This generally coincides with a significant market disruption (it also occurred in for periods during the financial crisis of 2008). The following figure from the popular blog VIX and More illustrates this.

(click to enlarge)

Watching these indicators in tandem, and not the VIX alone, gives a much fuller picture of the severity of market declines.

Current Low-VIX Interpretation

The VIX chart (along with other indicators) are reflecting the following sentiments:

1) There is a low probability of large intraday moves in the near term.

2) Geopolitical tensions currently in the news have not and will not have significant impact on the markets.

3) As long as central banks continue with their current policies and expectations, the structural risk we all feared has been abated.

As we will discuss below, these three points are interrelated.

Below is a chart compiled recently by Credit Suisse showing the number of days in a year where the SPX had intraday moves over 2%. Going back almost 25 years, we can see that there has been a noticeable trend lower in the past three years.

What this is saying is that short-term spikes in the VIX have been a good time to take some profits off the table - but don't throw out the kitchen sink. There will be an opportunity for getting back into the market at slightly lower levels and then ride the S&P to future record-breaking levels.

A low VIX in the face of negative headlines involving Ukraine and Iraq is not meant to be an indicator of the political seriousness of these events. Instead, it's a reflection that the collateral damage on the fiscal front will likely be minimal. The realization that 1) these separatist/terrorist rebellions have settled into a stalemate, and 2) that they are largely decoupled from the broader financial community is what has allowed the market to resume its record-breaking rise and the VIX to fall back to historically low levels.

Recently, investors have been able to get to the bottom of the collateral damage issue very quickly after the more sensationalist headlines have passed. In fact, in just one week it became clear that ISIL would not overrun Baghdad and Shiite-controlled areas to the south where much of Iraq's oil supply comes from. Interestingly, it was the United States signaling its willingness to intervene minimally only to prevent further terrorist advance (and not to win back territory lost) that sent the market higher. Because there was no significant disruption to the oil markets yet, the VIX didn't really budge.

Ukraine still pops up in the headlines, but the media is largely ignoring that Russia annexed Crimea a couple of months ago. The US and other members of the G7 consider this act to be illegal, but the VIX is implying correctly that the fiscal fallout will be minimal (indeed, Crimea was already a semi-autonomous region with heavy Russian influence).

The Table we showed earlier is also telling us that fiscal problems in the US and Europe are the scariest of all. The widespread belief that problems in southern Europe would spread to other countries was the source of much of the fear in 2010-12. We just didn't understand the level of interconnectedness and the severity of this "contagion," so markets sold off.

And here is the key lesson from watching the VIX: as long as the Federal Reserve and other central banks continue their coordinated, global effort and stand ready to "do what it takes" to prevent this from happening (to use Mario Draghi's words), there is no reason to panic.

Just the announcement that the end of QE was coming was enough to rattle the markets in mid-2013. The dreaded taper has arrived and monthly QE purchases have been cut by more than half. Yet markets have still done well simply because the Fed has promised to keep borrowing rates near zero. By "rigging the system" to reward equity investors over savers, they have ensured that stock markets will continue to be favorable relative to other investments.

The view that "a low VIX means trouble around the corner" is too simplistic. Lack of large intraday market moves, low collateral damage from conflicts, and the central bank assurances may simply mean that trouble has been abated for now.

Which is what the VIX has been telling us all along.

Source: The VIX Is All Right