Wall Street's Favorite Uncertainty Indicator Might be Losing Its Charm
Investors have no crystal ball to gauge risk levels when making investment decisions. Instead, they often rely on the VIX, the Volatility Index of the Chicago Board Options Exchange.
Marketed as a "fear gauge," this index hypothesizes to reflect market participants' estimates of future volatility (or the speed of price changes) within the next 30 days. A rising VIX suggests heightened anxiety and increased risk, while a falling VIX indicates a market transitioning into a less turbulent phase.
However, as markets grow more volatile, some analysts fear that this trusted indicator might be on the brink of collapse. Critics argue it does not function effectively in an atmosphere of uncertainty, where investors need it most.
Aaron Anderson, Senior Vice President of Research at Fisher Investments, said to me that the VIX is irrelevant for predicting stock movements. "There is no correlation with future returns. We've never understood why so many people place such value on the VIX."
In the past four days, markets have taken a nosedive, raising questions about the summer rebound. The VIX index is currently restoring this trend, albeit tentatively.
Deep Dive
Thirty-day window is considered a high benchmark for the VIX. The index fluctuated mostly around twenty in August, implying lower volatility. On Wednesday, it breached 25.
Scott Bauer, CEO of the Prosper Trading Academy, who has been working as a market maker at CBOE for the past 15 years, told me that in theory, if the index could accurately predict future market movements, it would have been marginally higher ahead of the sell-off.
Cliff Asness of AQR Capital Management agrees that the index carries limited value. "The VIX tells us almost nothing, apart from how strongly the market moved in the recent past"[1]. He noted that in the 1990s, the VIX-Index approximated the S&P 500 Index.
Fisher Investments analysts assert that if investors reflect on extreme highs or lows in the VIX, they might have missed a corresponding shift in the S&P 500.
There are instances where no correlation exists. Fisher analysts discovered that 1995 was a stellar year for markets with no correlation to the VIX.
Baum said that the index is not designed to be the handiest tool for retail investors as it serves institutional investors far more effectively. An entire derivatives industry hinges on this misconception that the CBOE created when it introduced the VIX in 1992. Although it was designed to help traders profit from market movement predictions, it was never meant to serve as the anxiety index it is now.
Conclusion
In uncertain times, we gravitate towards any promise of future certainty, and financial media certainly leverages the VIX for this purpose. But when factors remain unknown, the VIX is prone to failing.
Wall Street's Favorite Uncertainty Barometer: Broken or Just Misunderstood?
Wall Street funds and investors traditionally rely on the VIX Index, also known as the "fear gauge," to gauge the volatility levels of the market.
However, experts have questioned its viability deriving from increasingly volatile markets and its lack of accuracy in predicting future market movements when investor sentiment is red-flagged. Two experts discussed Bed Bath & Beyond's restructuring plan, which involves offloading some of its brands, and some suggested holding onto the BBBY stock, while others advocated against.
Dive Deep
The VIX index is recognized as an emotion-driven benchmark, reflecting the collective anxiety of the market. Its value stems from measuring the market's assessment of future volatility, implying that a higher VIX indicates more dread and risk. Despite its popularity, the VIX is marred by several limitations and concerns:
- Irrational Behavior: The VIX is a reflection of the market's collective emotional state, which can lead to irrational behavior. In times of high stress, investors may overreact or underreact, causing the VIX to spike or drop without accurate reflection of underlying risks.
- Technical Limitations: The VIX is derived from option prices of the S&P 500 index and measures the implied volatility of those options. It provides insights into market expectations but fails to accurately predict specific future market movements. It underscores the intensity of fear driving those movements, but it is not a direct predictor of stock prices.
- Noise vs. Signal: The VIX can be noisy, reflecting short-term market fluctuations rather than long-term fundamentals. This makes it difficult to distinguish between temporary panic and genuine systemic risk, both critical factors for making informed investment decisions.
- Contextual Understanding: For the VIX to deliver valid insights, it must be used alongside other indicators and in conjunction with a deep understanding of the underlying economic and geopolitical factors influencing the market. Without contextual understanding, it can lead to misinterpretation and poor decision-making.
- AI and its challenges: AI enhances the analysis of the VIX by leveraging diverse data sources to gain deeper insights into market volatility. However, AI models can be prone to overfitting or underfitting and their accuracy can be influenced by the quality and relevance of the data they process.
- Contrarian investing: While the VIX can be used as a contrarian tool, taking advantage of moments of fear and turning them into profitable opportunities requires discipline, emotional detachment, and a willingness to challenge prevailing sentiment.
In conclusion, the VIX is a valuable indicator, but its main critical challenge is its inability to accurately predict future market movements despite being a fear gauge.
