As equity markets sit near all-time highs, investors appear to be increasingly unnerved by the CBOE Volatility Index, or VIX, which is hovering near a historic low, and has indeed been drifting lower ever since the end of the financial crisis of 2008-2009. (The “CBOE” here is the Chicago Board Options Exchange, a subsidiary of CBOE Holdings (NASDAQ: CBOE).)
The state of the VIX suggests, depending on your disposition, that we’re either in for an extended period of stable returns (as the last eight years seem to suggest), or more ominously, that volatility will soon leap terrifically. The VIX is well-known as the “fear index” because spikes in volatility are often correlated with panic and market downturns, while muted volatility is generally accompanied by rising stock prices.
As my colleague John Maxfield points out, dwindling volatility, especially given the number of days this year in which the VIX has traded near a multiyear trough, is something of a mystery. I’ve read a number of potential explanations of this phenomenon, from evidence that VIX trading is manipulated, to quirks in options valuation on which VIX pricing is based.
Whatever the cause, the worst mistake stock investors can make right now is to overadjust investing strategy for the two very different implications of the current VIX level.
First, it’s important to understand that the VIX isn’t a predictor of forward volatility, although it does a pretty decent job of reflecting current volatility in the markets.
Rather, the VIX is a measure of the implied volatility over the next thirty days of various near-term S&P 500 Index options. According to the CBOE, the VIX seeks to measure in real time how much the market believes the S&P 500 will fluctuate over the next 30 days.
Scared by a relative absence of fear? Don’t make the mistake of wiping long-held positions clean just because the VIX has imploded, and you’re expecting a sudden cataclysmic event. An investor spooked and thus sidelined by the relative calm in the markets immediately following the financial crisis of 2008-2009 would have missed one of the longest bull markets in history, still intact to date.
Neither should you let the opposite interpretation, that we may have entered a long period of market calm, lull you into complacency and take the edge off your standard investment criteria.
Instead, it may be constructive to spend some time thinking about the types of volatility that really matter to you as a long-term investor. For example, consider evaluating the volatility of your own portfolio relative to the market.
Or consider the volatility of the earnings of companies you’ve bought shares in. Say you’ve invested in a Dividend Aristocrat that typically generates stable cash flows, and you notice that the earnings of that company have exhibited more volatility than usual over the last few quarters. It’s probably time to investigate your theoretically safe investment.
Likewise, if you’re keen on buying young, Foolish companies with world-changing products, then maybe you should embrace the volatility of earnings that companies capable of spiffy-pop growth characteristically exhibit.
Who should pay close attention to the silence of the VIX? Probably swing traders, day traders, and speculators. The shorter the time horizon, the more a broad move in the market has the potential to harm committed money, since steep market declines are correlated with breadth. In other words, on a really bad day (or sequence of days) in the market, most all stocks will lose.
Conversely, the longer you look to benefit from phenomenal companies that consistently amplify revenue, margins, and operating cash flows, the less the opinions of options traders gauging a month’s worth of market volatility should matter to you.
It’s said that Croesus, king of the Lydians, sent off to the oracle Amphiaraus and the oracle of Delphi to inquire if he should go to war with the Persians. We have it from Herodotus that “The two oracles … were in perfect agreement, for they both predicted that Croesus, if he did go to war with the Persians, would destroy a mighty empire.” On this advice, Croesus threw his forces into conflict, but was ultimately routed by the Persian leader Cyrus, whose cavalry attacked on dromedaries, the scent of which frightened the horses of Croesus’ army. An enraged Croesus belatedly realized that the predictions had come true — it’s just that the empire the oracles had referred to was his own. The VIX is a similar oracle: It’s most easily interpreted after the fact.
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