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What You Don't Know About The VIX

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The standard gauge of fear in the market – short-term implied equity volatility (the VIX) – recently touched an 18 month low. Some people think this is a sign of stability: the equity market has rocketed higher post-election, corporate earnings have rebounded and global growth is expected to increase. Others see the new low as a sign of complacency: the worst equity draw-downs often come when nobody expects them, and the low level of the VIX indicates limited demand for downside protection. The idea the VIX could be so low after witnessing such volatility over the last few months understandably seems unsettling to many investors. Is there something else going on? The answer in "yes."

The VIX is a measure of expected, or implied, volatility of the S&P 500 index. There are 500 companies in the index and on any given day, some stocks go up and some stocks go down. Movements in the index reflect the average market-cap weighted changes of individual companies. So, hypothetically, if half the companies were up 5% and the other half were down 5%, it's quite possible the index itself could be unchanged. Individual stocks could experience very high volatility, but the volatility of the index, which is comprised of the average stock movement, could be zero.

Another way to describe this phenomenon is correlation. When all stocks in the index are moving up and down in tandem, correlation is high, or positive. When individual stocks or sectors move in different directions, correlation is said to be low, or negative. When stocks are highly correlated to each other, the change in the index closely resembles the average change in individual companies. If all stocks go up 5%, the index goes up 5%. In low correlation environments, the index is not as volatile because stocks are more prone to move independently. Price changes in the index may not accurately reflect changes in the underlying companies. The recent fall in correlation can help explain the decline in the VIX.

As can be seen in the above chart, the implied correlation of the S&P 500 has fallen from a high of 0.75 in early November, 2016 to a current level of 0.20. This drop in correlation has taken place in a market which has experienced quite a bit of turbulent activity. But the turbulence has been primarily sector related and has not affected the market as a whole to the same extent. In fact, the ratio of realized volatility at the sector level to the broad index is the highest in 5 years. The chart below shows the equally weighted average of realized 90-day volatility of the main S&P sectors compared to the S&P 500.

The higher realized volatility at the sector level coincides with significant divergence, or dispersion, in total returns among the different S&P 500 components. In the last six months, the total return of the S&P 500 was 7.0%. However, the difference between the best performing sector (Financials) relative to the worst performing sector (Real Estate), was a whopping 32.6%. Clearly, there has been some massive rotation taking place. Of the ten sectors in the S&P 500, five underperformed the broad index and five outperformed. As a result, the index movement (the average of all stocks) has not been as large as individual stocks. That is why the low index volatility readings seem so unsettling. The market just feels more volatile than displayed in the VIX.

With the massive sector rotation, it would be unfair to say the current VIX level is related to a high degree of complacency. Investors in the Healthcare and Real Estate sectors are hardly euphoric about their relative returns in the last six months. Taken in this regard, the VIX reflects investor perception of high risk to individual stocks and sectors and relatively low risk to the market as a whole. Intuitively, this is justified given the huge policy uncertainty surrounding the change in government where there will be clear winners and losers. The next time you hear the pundits talk about the low level of the VIX and how it portends coming disaster, remember there might be something else to the move other than lack of respect for risk.

 

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