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I ran a study on how current levels of the VIX are related to returns over the subsequent year period. The data covers periods from 1990 to today. Interestingly, there is almost no overall correlation between the two (R-squared under 0.01). That is, knowing what the VIX is today is not likely to give you any aggregate useful information about whether returns will be high or low over the next year.

What little correlation there is suggests that buying the market at periods when the VIX is lower is a better strategy. (You can tell this from the downward sloped trend line on the chart below.)

click to enlarge
vix 1

Another question I examined: how well does the VIX predict actual REALIZED volatility over a subsequent twelve-month period? The answer to that is “reasonably well”, although, as you can see from the chart below, actual realized volatility (standard deviation) has never exceeded 30% over the past 17 years, and so one could conclude that the VIX has “always been wrong” when it exceeds 30%. Investors are often too fearful. (Two caveats, of course: 1) just because they have been too fearful over the past 17 years doesn’t mean their fear is not justified; and 2) the VIX, being a weighted average of implied volatilities on all manner of S&P options, short and long, is not necessarily calibrated to predict NTM volatility anyway.)

vix 2

Going back to the first chart, one might conclude that buying when the VIX is above a certain level is a bad strategy. However, digging into that a bit further illustrates the vagaries of statistics: in fact, buying the S&P on every day the VIX exceeded 30, and holding it for a year, resulted in an average return of 17.15% (as compared to the average return of 10.28% available for all twelve-month periods during the period in question). The market seems to pay an outsized return in exchange for the risk of buying when fear is high.

What does the preceding discussion imply for the future returns of the market from today’s level? Virtually nothing, as demonstrated by the low R-squared in the top chart. My bottom line is that there is plenty of room for divergent opinions; my view happens to be that the market will be weak over the next year or more.

Eric Boughton, CFA
Deschutes Investment Advisors

Source: The Predictive Value of the VIX: Room For Divergent Opinions