Markets & Economy

Asset Allocation

What Does a Low VIX Tell Us About the Market?

June 21, 2017
Historical evidence shows, over longer-term periods, a low VIX is generally positive for relative U.S. equity performance.

Key Points

  • Financial pundits cite low readings on the Chicago Board Options Exchange Volatility Index (VIX) as evidence of investor complacency and rising equity risk.
  • Historical evidence shows that, over the near term, investors typically overestimate the next 30-day volatility of the S&P 500 Index.
  • When the VIX has been low, U.S. equities have outperformed U.S. bonds on average over the next 12 months, regardless of the change in the VIX over that time horizon.
  • Without a meaningful and sustained catalyst, we don’t believe a low level of the VIX alone implies investor complacency or an immediate danger of a risk-off event.

BACKGROUND

There has been much discussion in the financial press recently about the danger of investor complacency—with a low VIX frequently cited as compelling evidence that equity investors have grown too relaxed about potential risks. The problem is that it is difficult to determine whether markets are truly complacent or not; we can’t survey all investors and, even if we could, how many investors would admit that they were complacent? Instead, we take a mental shortcut and presume that something we can measure is a good proxy for the thing we actually care about. Enter the VIX. In this article, we try to determine the usefulness of the VIX as a forward indicator for both market risks and market returns.

UNDERSTANDING THE VIX

The VIX can be interpreted as the market expectation for realized volatility over a forward 30-day period (Figure 1).1 While it is true that the VIX tends to be mean-reverting and it occasionally spikes following long periods of calm, it is more often the case that calm follows calm. It is very tempting to look at a time series of the VIX and assume that you want to “buy the VIX” when it’s low and “sell the VIX” when it’s high. Unfortunately, the VIX is not a stock that you can buy and hold, it is the strike price of a 30-day variance swap. When you buy a 30-day variance swap, the only thing that matters is the forward realized volatility of the underlying asset, not what the price of a similar 30-day swap will be at some point in the future.

If a low VIX were actually a good measure of investor complacency, there would be a corresponding relationship between a low VIX today and higher-than-expected volatility over the forward 30-day period. However, this is not the case. Consider the scatterplot shown in Figure 2, which compares expected volatility (VIX level) with forward realized volatility. Points above the line (with slope equal to 1) reflect investor complacency, while points below the line reflect the opposite. In the majority of cases, investors actually overestimate 30-day volatility,2 and even when they don’t, it is not a function of the prior level of the VIX but other factors that impact the underlying asset, the S&P 500 Index.

HISTORICAL RELATIONSHIP BETWEEN THE VIX AND U.S. EQUITY PERFORMANCE RELATIVE TO U.S. BONDS

The complacency argument implies that the forward performance of traditional risk-on asset classes will be negative when the VIX is too low. Although past performance cannot predict future performance, we evaluated the historical relationship between the VIX and the forward 12-month performance of the Russell 3000 Index (U.S. equities) relative to the Bloomberg Barclays U.S. Aggregate Bond Index (U.S. bonds). We looked at:

  • The level of the VIX versus forward 12-month equity returns relative to bonds and
  • The level and change in the VIX versus forward 12-month equity returns relative to bonds.

We compared the level of the VIX with subsequent 12-month relative returns on the Russell 3000 Index versus the Bloomberg Barclays U.S. Aggregate Bond Index over rolling 12-month periods running from January 1990 through December 2016 (Figure 3). Relative returns were sorted into three buckets based on initial VIX levels: A “low” VIX was defined as being in the bottom quartile of all readings over the period, “medium” VIX levels fell in the middle two quartiles, and top-quartile readings were considered “high” VIX levels.

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When the VIX was in the bottom quartile—corresponding with index readings of 10.3 to 13.9, U.S. equities outperformed U.S. bonds by an average of 8.4 percentage points over the next 12 months, with -1.4% as the 10th percentile return and 21% as the 90th percentile return. Further, U.S. equities outperformed U.S. bonds 88% of the time, while 12% of the time U.S. equities underperformed U.S. bonds. (For additional information on the study methodology, please see the appendix)

Considering both the level and the next 12-month change in the VIX may provide additional information. As shown in Figure 4, when the VIX was in the lowest quartile and increased by over 100 bps over the following 12 months (the scenario feared in the investor complacency argument), U.S. equities outperformed U.S. bonds by an average of 7.6 percentage points, with a 10th to 90th percentile return range of -3.4% to 21.6%. The overall hit rate—the percentage of the time that U.S. equities outperformed U.S. bonds—when the VIX was in the lowest quartile and rising was 81%, which means there was negative relative performance 19% of the time.

However, when the VIX has been in the two medium quartiles (25th to 75th percentile) and increased by more than 250 bps over the next 12 months, it historically has signaled negative relative performance over those next 12 months. In this type of environment, U.S. equities underperformed U.S. bonds by an average of -3.5 percentage points with a 10th to 90th percentile return range of -36.8% to 22.1%. The overall positive hit rate in the medium two VIX quartiles was 49%, which means 51% of the time there was negative relative performance.

Conclusion

While the empirical evidence shows there have been times when a low level of the VIX has underestimated forward realized volatility and U.S. bonds have outperformed U.S. equities, the number of occurrences has been relatively low. As a result, without a meaningful and prolonged catalyst, such as increased geopolitical concerns, unexpected global central bank policy changes, or negative economic data, we believe there is a low historical likelihood that the current level of the VIX implies investor complacency and/or an immediate risk-off event. While we claim neither that correlation is causation nor that history will repeat itself, we do not believe there is sufficient quantitative evidence today to argue this time will be different.

1 For a technical explanation of these concepts and their relationship to the VIX, see the appendix.

2A phenomenon known as the variance risk premium.

3“Arbitrage-free” refers to the fact that if you traded a variance swap at any price other than the arbitrage-free one at a point in time, you would be able to create a replicating portfolio that would exactly offset the risks of the variance swap, creating the potential for risk-free profits.

4There are some details, approximations, and caveats here, but these do not impact the broad statement.

 

Important Information

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of June 2017 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

Past performance cannot guarantee future results. All investments involve risk. All charts and tables are shown for illustrative purposes only.

Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell indexes. Russell® is a trademark of Russell Investment Group.

Bloomberg Index Services Ltd. Copyright 2017, Bloomberg Index Services Ltd. Used with permission.

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