Letting the VIX tell us when to get out

Can the VIX help us know when it’s time to leave the incredible party Wall Street is throwing?

That’s a crucial question following a day in which the Dow Jones Industrial Average DJIA +0.33%   surged to an all-time high and investors remained as confused as ever about how much further the bull market can go. And the question was on my radar screen anyway, since the VIX was prominently among the myriad indicators you collectively suggested to me in response to my offer two weeks ago to test which of them might have good track records at identifying market tops.

Unfortunately, my research suggests that the CBOE’s Volatility Index VIX -2.22%  leaves a lot to be desired as a market-timing indicator. In contrast to what many contrarians believe, low VIX levels are not bearish. And high levels are not necessarily bullish either. 

The VIX’s median level over the last couple of decades — the dividing line such that half the historical values are below it and half above it — is 18.8. As you can see in the accompanying table, the Wilshire 5000’s average 6- and 12-month returns following below-median VIX levels are higher than what they have been following above-median levels. 

When VIX is...	Subsequent 1 month	Subsequent 3 months	Subsequent 6 Months	Subsequent 12 months
Below median	0.9%	2.6%	5.6%	12.5%
Above median	0.9%	2.8%	5.2%	9.6%

To be sure, just the opposite is the case at the 1- and 3-month horizons. But these differences are not statistically significant at the 95% confidence level that statisticians often use to determine if a pattern is genuine. 

How could investors have been so wrong in their interpretation of the VIX? My hunch is that their mistake is thinking that it is a fear gauge, with low levels indicating excessive complacency and high levels an excess of fear. But fear is not really what the VIX measures.

Fear is not really what the VIX measures.

It instead is a measure of expected volatility, as reflected in option premiums. In the complex algorithm used to calculate the VIX, both big upside and big downside moves contribute more or less equally. Since these large up and down moves often largely cancel each other out, average market returns following high VIX levels are not higher than they are following low VIX levels. 

Some of you, in urging that I take a look at the VIX, suggested a different interpretation: Rather than on absolute levels, I should focus on where it stands in relative terms. Unfortunately, I was unable to find much value in this alternate approach — at least when I measured how the Wilshire 5000 total-return index performed whenever the VIX was above or below several of its moving averages. 

As you can see from the accompanying table, there are only minor differences between how the market proceeds to perform when the VIX is above its recent moving averages and when it’s below. And none of those differences is significant at the 95% confidence level. 

When VIX is	Subsequent 1 month	Subsequent 3 months	Subsequent 6 months	Subsequent 12 months
< 1 month average	0.9%	2.6%	5.1%	10.8%
> 1 month average	0.8%	2.5%	5.3%	11.0%
< 3 month average	1.0%	2.8%	5.9%	11.1%
> 3 month average	0.8%	2.3%	4.6%	10.5%
Entire sample	0.8%	2.5%	5.1%	10.8%

None of this is to suggest that there aren’t other ways in which the VIX might be used as part of a profitable market-timing strategy.

But I have my doubts when it comes to any of the more straightforward ways in which investors typically use the VIX.

Please bookmark us