Wednesday, March 28, 2012

The VIX and Future Returns

Along with the recent optimism among investors and improving news in Europe and the U.S., the VIX index of options volatility has trended lower to multi-year lows.  

A common misperception is that the current low level of the VIX means that lower stock prices are likely.  I think that lower stock prices are likely, but not for that reason.  (My main reason is that other measures of investor sentiment are at high levels, which have had a high correlation with subsequent declines in stock prices.)  

The VIX index can remain at low levels for some time while stock prices continue to rise.  The most recent example was the period from early 2003 to autumn 2007, when the VIX generally stayed below 21.  During this period, the S & P 500 Index nearly doubled (albeit with reversals along the way).

Over the last fifteen years, low levels of the VIX have coincided with slightly negative returns on the S & P 500.  High levels of the VIX are an entirely different matter.  The VIX is high when volatility (and fear) is high.  This is usually the best time to invest, particularly because it goes against human nature.  Over the past fifteen years, when the VIX is high (greater than 30), the S & P has returned nearly six times more than the long-term average return on stocks.

So yes, watch the VIX.  But remember how to interpret it.

Steve Lehman

S & P 500:  1412

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