Volatility in Scope: No Man’s Land

Mon, Nov 9, 2020 - 1:24pm

As of today, the volatility index (VIX) stands at 24.88 and is deeply confused about its market identity. Is it bullish, is it bearish, or is it non-binary? The VIX has not closed below 20 since pre-historic…excuse me, pre-COVID times. This stands contrary to the average VIX level from most all of 2016 through 2019 where only rare events led to a reading above the 20-level mark. Are we in a new age of volatility or is this simply the COVID cough still lingering in the volatility index?

Studying volatility from 1990 to today we can see how different regimes of the VIX brings different market returns. I have placed the VIX Index values into 3 groupings as seen in the table below.

vix ranges

We can now look forward in time to analyze how the S&P500 performed over the subsequent year from each of these different groupings.

spx forward returns
Source: Financial Sense Wealth Management, Bloomberg. Forward returns are for illustration purposes only and are no guarantee of future results. You cannot invest directly into an index.

The table above shows the annualized forward returns of the S&P500 for a 1, 3, 6 and 12-month time period when the VIX is sitting at the three groupings previously discussed. Let’s save the best for last and first look at group 2, our “Neutral VIX” grouping. These annualized forward returns seemed to provide the worst readings. This is where we have spent the majority of 2020. The volatility index has not closed below 20 this year and has ventured into our High VIX grouping several times as COVID continues to linger in our society. Group 2 seemingly signals a market identity crisis from the perspective of volatility. Complacency during these times must be extremely measured.

Our High VIX group, Group 1, returns the best results. This does not mean that higher volatility leads to higher returns, however. What it does mean is that if you start to invest at a period of high volatility where mean reversion plays a large role, you can expect good forward returns because things likely won’t get worse based on historical readings. This idea is best shown by the chart below.

spx 12m forward returns
Source: Financial Sense Wealth Management, Bloomberg. Forward returns are for illustration purposes only and are no guarantee of future results. You cannot invest directly into an index.

For the most part, the higher the VIX reading, the more likely negative returns become and vice versa. Group 3 for low VIX readings show us that the majority of the time spent here provides us with relatively average forward returns with subdued losses. Group 2 seems to show its true colors when the VIX gets beyond 16 or so and losses can become large, easily reaching into double-digit territory. Sure, higher returns become more frequent, but uncertainty rises to barely palpable levels. Group 1 could likely be split into two categories as it exhibits two characteristics. The first being subdued positive returns with bear market losses becoming the norm. The second being its mean-reversion characteristic experienced with readings towards the furthest right end of the X-axis. Although, we would hope mean reversion would play a role at whatever the highest X-axis value is because without that market characteristic we would have likely experienced a serious meltdown of the global financial system at this point.

Overall, the VIX is unsure of its path forward. We can expect a greater deal of uncertainty in returns going forward from where we are now, which is also a reflection of our current geopolitical and global pandemic backdrop. Higher losses and slightly higher than average gains are likely to continue until these macro variables find their place in the equation.

Advisory services offered through Financial Sense® Advisors, Inc., a registered investment adviser. Securities offered through Financial Sense® Securities, Inc., Member FINRA/SIPC. DBA Financial Sense® Wealth Management.

Copyright © 2020 Ryan Preiss

About the Author

Associate Wealth Manager
Financial Sense® Wealth Management
ryan [dot] preiss [at] financialsense [dot] com ()
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