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VIX Signaling No Recession?
Why the market "fear gauge" may not be broken
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I’ve heard over the last few months that we’re not close to a bottom because the VIX hasn’t blown out past 45.
Technically, he’s not wrong but he’s also not right. If we look back all the way to the start of 1990, the VIX has been at, or above, 45 exactly 112 times.
The most notable times were in 1998, 2002, 2008, 2010, 2011, and 2020. But there’s an issue in how people think that the market needs to blow past 45 to signal the bottom. Before we get to that, we need to remind people what exactly the VIX is, and what drives its movements.
What is the VIX Index?
The Cboe Volatility Index (VIX) is a real-time index that represents the market’s expectations for the relative strength of near-term price changes of the S&P 500 Index (SPX). Because it is derived from the prices of SPX index options with near-term expiration dates, it generates a 30-day forward projection of volatility.
Volatility, or how fast prices change, is often seen as a way to gauge market sentiment, and in particular the degree of fear among market participants. It is an important index in the world of trading and investment because it provides a quantifiable measure of market risk and investors’ sentiments.
How does the VIX work?
The VIX attempts to measure the magnitude of price movements of the S&P 500 (i.e., its volatility). The more dramatic the price swings are in the index, the higher the level of volatility, and vice versa.
Is the VIX broken?
Many believe that the VIX not hovering at 40 given all the bad news this year (war in Ukraine, inflation, tech getting destroyed, crypto funds and platforms blowing up) means that the index is broken, but what many need to realize is that history doesn’t repeat. It rhymes.
If we look at the 2008 Great Financial Crisis as a reference point, we can see that even while the S&P 500 was declining from its over 1,400 price at the beginning of the year, the VIX was very much calm. This near 20 level kept signaling “buy” to the general investor.
What’s interesting is that the VIX barely spiked when Bear Stearns collapsed and was sold to JP Morgan (first yellow dot) and spiked to 31 the day that Lehman Brothers collapsed (second dot).
These two events of major investment banks failing would have sent shock waves to a rational market, but even then, the market was still downplaying the severity of what would become the global financial crisis (GFC).
It was only towards the end of September that so much news was released that started sending the markets into another decline before dropping off a cliff.
Monday, September 15, 2008:
Bank of America agrees to a $50 billion rescue package for Merrill Lynch.
Lehman files for bankruptcy.
US officials agree to put together a $20 billion lifeline bid for insurance giant AIG. The
Tuesday, September 16, 2008:
Wall Street titan Goldman Sachs reports 70% drop in profits.
Barclays formalizes the acquisition of Lehman’s US assets.
The US government announces it will give AIG $85 billion to keep it afloat, in return for an 80% equity stake in the company.
Wednesday, September 17, 2008:
Russia suspends stock market trading while Libor hits a seven-year high as the panic escalates.
Morgan Stanley’s shares fall 30% as it becomes the latest bank under fire.
Tuesday, September 23, 2008:
Political opposition to the $700 billion bailout plan grows in Washington pulling stock markets down.
Wednesday, September 24, 2008:
Warren Buffet invests $5 billion in Goldman Sachs and warns that failure to agree to a $700 billion bailout could result in an “economic Pearl Harbor.” The FBI starts to investigate the role of Fannie Mae, Freddie Mac, AIG and Lehman Brothers over their role in the sub-prime mortgage crisis.
Thursday, September 25, 2008:
Ireland becomes the first state in the Eurozone to fall into recession
Friday, September 26, 2008:
America’s biggest savings-and-loan company, Washington Mutual, is seized by federal regulators and sold to J.P. Morgan for $ 1.9 million in a deal that sends shockwaves through Wall Street and Main Street alike.
WaMu thus becomes the largest thrift failure with $307 billion in assets.
Sunday, September 28, 2008:
In Iceland, the government is forced to take control of one of the nation’s biggest banks.
In America, Citigroup snaps up troubled bank Wachovia for $2.1 billion in stock.
George Bush publicly urges the House of Representatives to pass the $700 bailout plan. His speech falls on deaf ears and a few hours later the House votes the plan down, 228 against 205. Wall Street has a fit, and the Dow plunges 777 points, its biggest-ever fall.
Citigroup agrees to acquire Wachovia.
Anyways, you get the gist. By the end of September, the music wasn’t slowing down anymore. It came to a screeching halt and the dominoes fell hard and fast.
Before this, it was a very orderly decline. Vaguely similar to now.
If we dial it back to the peak of last year (November 2021) to now, there have been way more dramatic jumps and declines in the VIX as if fear were suddenly turned on and off like a switch. Yet, the S&P has still continued its overall decline despite a recent rise off the lows from inflation.
The biggest question is, are we going to just continue in an orderly decline, possibly plateau? Well, when option traders expect bigger moves in the S&P, they are willing to pay more for options.
Speculators can bet that swings in the stock market will be getting bigger, and they sometimes make those bets when historical volatility has been subdued. Anything might trigger a rise in option prices—yesterday’s dip, a higher Fed rate hike, or Russia setting off a tactical nuke out of desperation.
At the moment, the VIX is well above its long-run average of 19%, but is nowhere near the scary level seen at the beginning of the pandemic.
Alongside all the other strange things happening in markets this year is the VIX’s increasing propensity to move in the same direction as equities. While such synchronization isn’t unprecedented, the frequency of occurrences has become extreme. October saw this four times where the two have posted tandem moves, or 25% of the time. That’s above the historic rate of 22%.
“There is plenty of precedent for realized vol well below 30 and even below 20 in strong S&P 500 selloffs and even in recessions, so a low-20’s VIX would not be unusual”
Is the VIX broken? Not necessarily, but that doesn’t mean that the market isn’t in for more trouble. Unless there’s a series of major events that will blow out implied volatility, we can expect more of these random spikes and drops while the S&P continues its wild intraday moves.
Perhaps don’t try and play the VIX game and don’t get too caught up in the past historical readings of it.
Remember, history doesn’t need to repeat. It can just rhyme.
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Until next time,
Paul Cerro | Cedar Grove Capital
Personal Twitter: @paulcerro
Fund Twitter: @cedargrovecm