In this post, I’ll be looking at another market indicator, the VIX, which is otherwise known as the fear index. The Chicago Board Options Exchange Market Volatility Index measures the expected market volatility over the next 30 days. When VIX is low, there is a low expectation of volatility; and when high, the opposite is true. The VIX is quoted in percentage points, and roughly correlates with the expected annualized percentage change of the S&P 500.
Looking at monthly data starting in 1990, the VIX has ranged from about 10 at the end of January 2007 to about 60 at the end of October 2008. The highest reading ever was an intra-day high 89.53 on October, 24th 2008. In fact, 7 of the highest 10 readings have occurred since the financial crisis started in 2008.
To find returns, we’ve sorted the VIX into deciles, from lowest to highest. We then used Ken French’s high relative strength database (explained here) to determine the average percentage of growth 3, 6, and 12 months out.
Chart 1: Average Relative Strength Returns by VIX Decile.
The returns tend to have a U shape, with high returns at both extremes of the VIX. This is true when looking at all three periods (3, 6, and 12 months). Furthermore, average returns have been best when the VIX is extremely high rather than extremely low. To get some perspective, the bottom 20% of month-end readings range from 10 to 13, and the top 20% range from 25 to 60.
Even though some of the largest growth rates have occurred when the VIX is high, we must remember that most investors are risk averse and prefer low volatility. Therefore, convincing clients to invest when the VIX is high may be a daunting task. If you’d like to read more, both the VIX index and the preference for low volatility are discussed in this previous blog post.
There have been consistent relative strength return trends when looking at VIX readings over the past 22 years. If these trends continue, there may be high future returns next time the VIX hits an extreme level.