Schaeffer's Trading Floor Blog

What Does a Low VIX Mean for the Market?

What the market has historically returned in a low-VIX environment

by 5/27/2014 7:27 AM
Stocks quoted in this article:

The CBOE Volatility Index (VIX) is making seven-year lows! We're too complacent, doesn't everybody know this won't last forever, sell everything!

OK, I'm going a little straw man here, but that's the basic impression I've gotten on Twitter and StockTwits over these last few trading days. And on TV as well.

Is it good advice to go to the mattresses here?

Well, not really.

VIX closed under 12 last Wednesday for the first time in 2014. I'm not big on making VIX rules based on absolute numbers, I prefer using Bollinger Bands or moving averages. But I thought "hey, let's do a study based on an absolute number anyway."

And it turns out great minds think alike. Actually, greater minds than mine. Our own Rocky White had the same thought!

In my own study, I looked at all the times over the last 20 years or so that VIX closed under 12 for the first time in at least a month. Then I looked to see how the market fared one month, three months and six months out (I used 21, 63 and 126 trading days, actually). Here's how the SPDR S&P 500 ETF Trust (SPY) did each time, and at the bottom I have the average returns.

SPY returns after the VIX drops below 12

The blank spots are overlaps and I didn't want to double-count data.

Anyways, as you can see, the market has actually done quite well going forward, particularly three months and six months out. It was higher nine of 10 instances three months out, and all nine times six months out.

It does actually underperform one month out. The median return of buying SPY and holding it for a month is 1.17% over the history of SPY. But three months out, the median SPY return is 2.8%, versus 4.32% if you buy it the first time VIX closes under 12. And six months out, the median SPY return is 5.36%, versus 7.09% under these "cheap" VIX conditions.

So long story short, buying and holding when VIX gets this low is actually a good strategy!

It's important to think about why that's the case. Low VIX doesn't "cause" SPY to rally, much the way umbrellas don't cause it to rain. The relationship is backwards. VIX is typically low because the market is doing well, and in a peaceful manner. It's a confirmation of the trend that you could see even if VIX didn't exist. And trends are slower to change than we all think. Everyone on TV and on Twitter wants to call a turn, but the reality is that turns are relatively infrequent. And over-complacency is a lousy way to time a turn.

VIX is a good market timer at times, but those times are generally when it's telling a different story than the market itself. This isn't one of those times, it's just confirming things we already know.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.

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