The Misuse of the Stock Market's "Fear Index"

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Though contrarians believe that a high VIX signals a good time to buy stocks, history suggests that this is usually not the case.
True or false: Low VIX levels are a reliable sell signal for stocks.

If you answered "true," you're in good company. The conventional wisdom about the Chicago Board Option Exchange's Market Volatility Index, known more familiarly as the VIX, is that it is a contrarian indicator.

If the VIX, a widely-regarded indicator of investor fear, is low, that means that investors have lost their fear and instead have grown optimistic and complacent. To a contrarian, that means that the next leg for the market is down.

After all, the VIX was trading on the low-end of its historical range in October 2007, the stock-market high before a building financial crisis sent stocks into bear-market territory over the next 16 months.

In fact, however, the correct answer is "false." The historical record does not support this contrarian interpretation of the VIX. The stock market has actually produced above-average returns when the VIX is low.

Consider the results of an analysis of the VIX back to 1986, 25 years ago. (Note carefully that the CBOE has calculated the VIX only back to 1990. To extend the data back to 1986, which I did to encompass the 1987 Crash, I chained the post-1990 data together with data for the VXO, which is the volatility index that the CBOE used to calculate prior to the VIX, using a slightly different methodology.)

The VIX's median level over the last couple of decades—the dividing line such that half the historical values are below it and half above it—is 19.4. Believe it or not, the stock market's average return following below-median VIX levels is higher than what it is following above-median levels—regardless of whether we are measuring those returns over the following day, week, or month.

This is just the opposite of what the contrarian interpretation of the VIX would expect.

How could the contrarians have gotten it so wrong? One big reason, I suspect, is that they think the VIX is a gauge of investor fear. The notion is not—strictly speaking—accurate.

The VIX instead measures expected volatility, and both big upside and big downside moves contribute in more or less equal measures to higher volatility. Since these large up and down moves often largely cancel each other out, average market returns following high VIX levels are not higher than they are following low VIX levels.

Though the contrarian interpretation of the VIX is therefore not well supported by the data, there is at least one other pattern of note. It turns out that periods of high volatility tend to be clustered together rather than occur randomly. To put that another way: Big daily moves in the market tend to follow in close succession to other big daily moves.

This tendency raises the possibility that a risk-averse investor can sidestep a large portion of the market's volatility by simply getting out of stocks whenever the VIX starts to rise significantly. And since the market's returns during periods of high volatility are not abnormally high, this risk-averse investor is not forfeiting an intolerable amount of the market's overall return.

To illustrate, consider a very simple market timing model that uses the VIX at the beginning of each month to switch between the stock market and 90-day Treasury bills. If the VIX is below its median level of 19.4, the portfolio becomes 100% invested in the Wilshire 5000 index, and otherwise in Treasury Bills. From early 1986 through this past September 30, this portfolio would have produced an 8.0% annualized return, in contrast to 9.0% for buying and holding.

What is noteworthy about this 8.0% return is that it was produced with less than half the volatility, or risk, of buying and holding. In other words, to save more than half the risk of holding stocks, this portfolio had to give up just one percentage point per year of return. That's a winning combination.

Of course, this is a very simple model, offered for illustration purposes only. There are no doubt a number of ways that a more sophisticated model could be developed along these lines.

But at its current level in the mid-to-high 30s, the message of the VIX is that we should expect well-above-average volatility in coming sessions. Far from being a reason to run out and buy stocks, as the naïve contrarian interpretation would suggest, this high VIX level might be better seen as a reason to stay out of stocks until things calm down.

Furthermore, the message of the VIX futures market right now is that the VIX will remain high for at least several months. Even the futures contract expiring six months from now is suggesting that the VIX will then still be above 30. This suggests that it may take a lot longer than we think for the market to calm down.

One word of caution comes from Menachem Brenner, professor of finance at the Stern School of Business at New York University. In an interview, Brenner pointed out that it's hard to know what effect VIX options and VIX futures will have on the behavior of the VIX itself. For most of the VIX's history, after all, these derivatives did not exist. He pointed out that it's entirely possible that previous patterns in the VIX will not repeat.

So we need to be careful of placing too much importance on the historical pattern that led to the success of the simple timing model I discussed above.

Notice, though, what Professor Brenner's note of caution means for the naïve contrarian interpretation of the VIX's significance: Even if it had in the past been right, which of course it was not, you still would want to think twice before interpreting future VIX levels in the same way.