What's Really Driving Stock Volatility?

If you use the VIX Index to gauge sentiment, value, or short-term market direction, or if you are hedging or speculating with VIX-based exchange-traded notes, or ETNs, you'll want to read what follows. Normally, the VIX has some predictive value as a short-term stock market indicator, but that may no longer be the case.

I was wrong
First, a mea culpa. In August 2010, I wrote: "Don't go out and short the SPDR S&P 500 ETF or the Vanguard S&P 500 ETF (NYS: VOO) on this basis. As far as I know, the VIX isn't reliable enough to enable you to time the market."

A few days later, I compounded my error when I wrote, "I'd suggest that at extreme values, it becomes a good long-term indicator of stock market valuation."

I now regret to say that I made both statements on the basis of intuition, not a careful examination of the evidence. The first statement is misleading, verging on outright falsehood, because there is some evidence it is predictive in the short term (though I still believe that investors should refrain from this type of short-term trading strategy, except as a form of recreation).

Is this extreme enough for you?
The second statement is true -- to a narrow degree. During its relatively short history -- the VIX series starts in 1990 -- peak values of the index did coincide with attractive stock market valuations during the fourth quarter of 2008 through the first quarter of 2009.

However, spikes in the VIX (blue line, left-hand index) also coincided with very different levels of the S&P 500's cyclically adjusted price-to-earnings ratio (P/E10, red line, right-hand index) -- including the all-time high valuation achieved at the top of the bubble in early 2000.


Source: Robert Shiller, CBOE

Do low VIX values indicate stock market overvaluation? It's impossible to tell, since stocks were overpriced virtually throughout the history of the VIX Index. As Jeremy Grantham, the 'G' in fund manager GMO, wrote in July 2009, "After 20 years of more or less permanent overpricing of the S&P, we get five months of underpricing."

Bottom line: The VIX Index is not a useful or reliable indicator of long-term stock market value.

From long to short
On the other hand, there is quite a bit of evidence to support the validity of the VIX as a short-term indicator. In 2004, Goldman Sachs wrote in a presentation that "the VIX has been a successful market timing indicator, and has shown quite strong mean reversion itself." (Under mean reversion, above-average VIX values tend to be followed by below-average values, and vice-versa; stock returns share the same property.)

However, that relationship may be breaking down. That's bad news if you are using VIX-based exchange-traded products to speculate or hedge for your stock portfolio, or if you use the short-term indicator. The problem is that current VIX values may now reflect the trading activity in the VIX futures, rather than the other way around (VIX futures are based the underlying VIX index, with some premium or discount based on the futures delivery date).

It's blowing up!
Exploding volumes in VIX-related exchange-traded products, or ETPs, specifically the iPath S&P 500 VIX Short-Term Futures ETN (NYS: VXX) and the VelocityShares Daily 2x VIX ETN (NYS: TVIX) , are the culprit. As ETP providers ramp up their activity in order to rebalance their mushrooming futures positions, it could buffet the pricing relationship between the futures and the underlying index.

This "dog wagging the tail" is also observable with other ETPs. Shareholders of the iShares Silver Trust (NYS: SLV) and the SPDR Gold Shares (NYS: GLD) may be interested in a forthcoming article in the Journal of Derivatives and Hedge Funds which concludes that flows in and out of precious metal exchange-traded products are affecting spot precious metal prices.

A worrisome precedent
An earlier example of this phenomenon occurred during the Crash of 1987 as equity fund managers sold large quantities of S&P 500 futures to hedge their stock portfolios. As index arbitrageurs bought the index futures and sold the basket of underlying stocks to bring the futures and the cash market back into line, this contributed to further stock price declines. In the case of VIX-related products, the ETN providers play the role of the index arbitrageurs in '87. That's hardly a reassuring precedent.

Thankfully, there are easier ways to make money than exchange-traded notes backed by swaps and futures. Simple works best, and that principle applies perfectly to the one stock that earned the title of "The Motley Fool's Top Stock for 2012." To learn about this rare opportunity, request your free report.

At the time thisarticle was published

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