Is The Latest VIX Decline A Trick Or A Treat?
James Picerno | Oct 30, 2014 07:44AM ET
It’s nearly Halloween, but the frightening rise in US stock market volatility earlier this month is looking less creepy at the moment. In particular, the percentile ranks . In the first graph below, it’s clear that the VIX has fallen sharply in recent days after reaching high-risk levels earlier in the month. As of yesterday, the VIX dropped to a relatively benign percentile rank of 51 (based on a rolling 3-year window of data ). But other estimates of volatility (see definitions below) have yet to exhibit a similar drop and instead remain at or near the threatening 90th percentile range. In other words, only the VIX is signaling that the danger has passed.
A similar story unfolds when we look at the same indicators for a trailing 10-year window, which crunches a considerably longer stretch of history. Here, too, the VIX looks far less threatening at the moment, in contrast with other measures of market risk. It’s worth noting that the 10-year window (arguably a more robust benchmark vs. the 3-year rolling history) never rose to the critical level (above the 90th percentile rank). As such, one could argue that the recent increase in volatility was never a strategic threat to begin with.
In any case, why is the VIX signaling a sharply lesser level of market risk vs. alternative measures? Methodology explains the difference. The VIX reflects the crowd’s expectations for volatility over the next 30 days and so it’s a forward-looking metric, albeit one that’s based on the market’s guesstimate and so all the usual caveats apply. The other metrics in the charts above provide a rear-view mirror perspective. In other words, the contrasting estimates of market risk can be summed up as differences between ex-ante and ex-post estimates.
Which one is right? The strongest signals arise when all the metrics are telling a similar story. By that standard, we’re still in a transition phase. The latest pullback in the VIX implies that the recent surge in volatility was a false alarm in terms of expecting an extended run of trouble for the bull market. But that’s a forecast. Confirmation that the crowd’s expectations are in fact accurate has yet to arrive in the ex post data. That said, we’re starting to see the rear-view metrics inch lower.
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One can read the decline in the VIX as a prediction that trailing volatility measures will soon decline. If so, that would be a bullish signal. But for the moment, it’s still debatable if the market’s recent bout of instability was a false warning of things to come or a genuine sign that big-picture trend has changed for the worse.
One reason for cautious optimism: the encouraging state of macro. As long as the US economic profile remains upbeat, as it has lately, it’s easier to assume that Mr. Market’s latest hissy fit was a temporary bump in an ongoing bull market.
VIX: market expectation of near term volatility for S&P 500 via index option prices.
EMA: 30-day exponential moving average of the S&P 500’s squared daily % return.
SD: 30-day standard deviation of the S&P 500’s daily % return
Garch.norm: a Garch(1,1) model that assumes a normal distribution via the rugarch package in R.
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