Assessing Extreme Volatility: Implications For The S&P 500

Includes: SPY, VXX, VXZ
by: Prieur du Plessis

The extreme volatility in U.S. equity markets and other global equity markets prompted me to analyse the current situation in comparison with history and to ascertain what causes significant changes in volatility.

The CBOE S&P 500 Volatility Index, better known as VIX, is constructed by using the implied 30-day volatilities of a wide range of S&P 500 Index put and call options. With the VIX only available from 1990 I have extended the volatility index by adding the CBOE S&P 100 Volatility Index or VXO from 1986 to 1989 to the VIX series.

The VIX is generally used as an indicator of greed/complacency or fear. I call it the pulse of the market. Any move above the average of 20.8 is a reflection of anxiety, while a move below is a reflection of calmness. The current anxiety of the market is clearly evident in the graph below (click to enlarge images):

Sources: CBOE; Plexus Asset Management.

In the graph below I indicate the average VIX since 1986 (20.8) with one standard deviation above (28.8) and one below the average (12.8). It is evident that VIX values greater than one standard deviation above the average can generally be associated with a large amount of volatility as a result of significant events – as is the case currently.

Sources: CBOE; Plexus Asset Management.

During sustained bull markets the pulse of the market is calm but moves towards neutral and anxiety towards the end of rising markets and the commencement of declining markets. It was evident in the run-up to the 1987 crash when the market went into anxiety mode nine months prior as well as at the end of 1989. In 1997 the VIX started trending towards neutral and anxiety mode three years prior to the spectacular end of the extended bull market in 2000. Anxiety persisted until the first quarter of 2003 before calmness set in. In the second quarter of 2007 the VIX started to trend to neutral and anxiety mode 12 months before the S&P 500 topped out and entered a declining trend. Although the market briefly went into a period of calmness in the first quarter of last year this was followed by brief snaps of anxiety and calmness, ending in the current state of anxiety.

Sources: CBOE; I-Net Bridge; Plexus Asset Management.

But what is the main determinant of volatility as measured by VIX? Greed and fear from my point of view as investor is not indifferent to expanded or contracted market valuation levels. I therefore used Robert Shiller’s PE10 where the price level of the S&P 500 is expressed as a ratio to the average trailing earnings of the past ten years as valuation model and compared it to VIX.

Sources: CBOE; Robert Shiller; Plexus Asset Management.


  • The significant jump in the PE10 from 13.4 in 1986 to 18.3 in 1987 was accompanied by a significant increase in volatility and therefore anxiety as measured by VIX. The volatility only returned to neutral levels after the crash of 1987 induced by program trading when the PE10 retreated to 13.4 or to pre-blow-off levels.
  • 1990 mirrored 1987’s situation with the Gulf Crisis the trigger to bring valuation levels back to levels that restored calm in the markets. In 1997 the VIX started trending towards neutral and anxiety mode as the PE10 rose.
  • Although the Asian crisis in 1997 increased anxiety or volatility it had no lasting effect on the PE10. The Russian crisis of 1998 also had no lasting impact as the PE10 briefly fell from 38 times to 33.5 and rose further afterwards.
  • Volatility remained at anxiety levels until the market topped out early in 2001 with a PE10 of 44.2 when the Dotcom bubble burst. The tragic 9/11 followed and corporate scandals such as Enron kept the anxiety levels high but the PE10 remained at elevated levels above 30.
  • The September 2002 market crash led the PE10 to bottom in February 2003 at 21.2 – levels similar to that of 1995 when the market last experienced “calmness”. The VIX dropped significantly and the PE10 thereafter remained stable at around 26 for the next 4 years.
  • In June 1997 the VIX again rose to and reached anxiety levels in July that year. As anxiety increased the market finally cracked in January 2008 as the PE10 started to fall as the subprime crisis unfolded and crashed in October as volatility increased significantly on the back of the Lehman saga and ensuing interbank collapse. Anxiety started to subside only when the PE10 dropped to a level of 13.3.
  • The debt crisis in Greece in June last year saw a significant increase in volatility but the PE10 retreated moderately to 19.7 from 21.8 in April. Calmness was restored and the PE10 rose to 23.7 in May.
  • Since then anxiety levels have increased as the European debt crisis deepened and a consumer confidence crisis in the U.S. developed. At the same time the PE10 dropped to 19.8, which is where we are now.

I also assessed the impact of the underlying economy on volatility or VIX. I identified two major indicators of the underlying economy in my analysis, namely consumer sentiment and my calculated GDP-weighted PMI for manufacturing and non-manufacturing combined.

Until the end of 2007 the Conference Board Consumer Sentiment Index (please note the reverse axis) and VIX maintained a narrow relationship but it broke down early in 2007. In August 2007 the Consumer Sentiment Index started to weaken when VIX entered anxiety territory and continued to weaken through March 2008. Sentiment only started to improve when the S&P 500’s volatility started to subside.

Sources: CBOE; Conference Board; Plexus Asset Management.

It is evident that high volatility is consistent with a GDP-weighted PMI below 57 (please note the reverse order of the PMI axis). From July 2006 the PMI started to falter but the VIX remained in “calmness” territory until a year later when the VIX caught up.

Sources: CBOE; ISM; Plexus Asset Management.

The relationship since July 2007 when the VIX entered anxiety level is evident in the following graph (please note the reverse order of the PMI axis). Until September 2008 the VIX reflected the underlying level of the PMI, but since then it has led the PMI by approximately one month. A major diversion is evident in March this year, though. The PMI weakened significantly from February to April but the VIX kept on declining and only started to play catch up in July. Currently the VIX is pointing to the PMI falling to 50 and below in September/October.

Sources: CBOE; ISM; Plexus Asset Management.

In summary, it is clear to me that the volatility of the equity market and that of the S&P 500 in particular as measured by VIX is influenced by valuation levels and the underlying economic trends. But what are the mechanics behind it and who is responsible for the increase in volatility?

Suffice it to argue that when the majority of investors become concerned about extended valuation levels and/or the threat of weaker economic circumstances ahead, the demand for derivatives to lock in profits and to reduce downside risk increases. The demand for, say, put options increases, resulting in higher prices of the options. The higher value investors are willing to pay for put options theoretically implies a higher value for volatility. The implied volatility of the options therefore increases and so does VIX. Therefore it can be said that investors are willing to pay more for the same option and thus are inclined to accept higher volatility.

On the other hand the writer or grantor of the option has the choice of leaving the option naked, thereby effectively going long of the market or to delta-neutral hedge the option by selling sufficient exposure of the underlying asset or the S&P 500 against the written option. The writers of put options who are bullish in a strong rising market tend to do so to collect the premium on the option to boost income.

When the S&P 500 starts to lose momentum or fall, the grantors of the options need to neutralise their positions by selling the underlying asset or buy put options as their value at risk increases. A vicious circle ensues. The price of the underlying asset (in this case the S&P 500) drops and actual volatility increases, while the implied volatility soars due to higher demand for put options. The volatility and downside of the market is often exacerbated by investment banks and other institutions who granted far out of the money put options for plain premium income considerations that all of a sudden threatens the balance sheets of the grantors. The grantors are then forced to sell indiscriminately to protect their balance sheets at all costs.

The price of the underlying asset continues to drop until it finds a level where the majority of investors become less risk averse and comfortable enough to buy the underlying asset. Demand for protective measures falls away and so does VIX as implied volatility drops.

What about the current situation? Where is the VIX heading? What are the implications for the S&P 500?

The current situation is similar to that of the middle of last year with concerns about the global economy given the debt stress in Europe, a weakening trend of the U.S. GDP-weighted ISM PMI and weakening consumer sentiment. The rating of the S&P 500 as measured by the earnings yield (inverse of PE10) is at levels similar to those in July/August last year.

Sources: CBOE; Robert Shiller; Plexus Asset Management.

The current rating is in the same region as in 2003 after which the market turned for the better and volatility dropped. It is evident that the market is extremely vulnerable to further shocks that could see a surge in volatility and a further massive derating. Barring any other unforeseen crisis that could lead to a further spurt in volatility, I believe the S&P 500 offers value at this stage.

But do the majority of other investors share my view? Only time will tell, as calm needs to be restored before we will see any sustained upward momentum in the S&P 500 and other global equity markets. What is clear to me is that the market has entered a period of above-average volatility that is likely to be sustained in coming years − similar to that of 1997 – 2003.

Sources: CBOE; I-Net Bridge; Plexus Asset Management.

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