By: Steve Smith
Stock market volatility has increased substantially over the past two months. While large declines during the first week of February and over the past few days have garnered most of the attention, it should be noted that the S&P 500 has spent over 30 of past 40 trading days within 3% of all time highs. At the moment, the market data hardly supports a recession prediction in this area.
Despite that, the main measure of market volatility, the CBOE Market Volatility Index or VIX, has more than doubled from 2017 levels and remains stubbornly near 4-year highs.
The VIX is often referred to as ‘the fear index’ because it has a tendency to rise, often quite dramatically, when stocks sell-off.
The basic reason for this inverse relationship is that the stock market declines investors begin purchasing put options on the S&P 500 as a means of establishing downside portfolio protection. The faster and larger the decline the greater the demand and the more people are willing to pay for the puts. This leads to pump in premiums which is translated into a higher implied volatility or high VIX reading.
But one thing to keep in mind is that implied volatility is not indicative or predictive of whether prices are rising or declining; it only tries to account for the expected magnitude and speed of a change in price, not the direction.
Too many market participants believe rising stock market volatility can only occur in down markets. It might be true that rising volatility is considerably more likely to occur in times of market stress, but the correlation is nowhere near as certain as most pundits believe.
Perhaps the most notable period in which we saw a bull market accompanied by an increase in volatility or the VIX was during the late 1990’s dot.com days.
During this time the S&P 500 more than doubled, but so did the realized volatility. 90-day historical volatility went from 8% to spiking above 25%, with the average firmly pushing 20%.
Please don’t misconstrue this as some sort of proclamation that VIX is heading higher.