For some investors, deciding when to get in and out of the market has less to do with central bank announcements, interest-rate moves or the size of government bailouts, and more to do with investor emotion as measured by the CBOE Volatility Index. The VIX, a real-time measure of expected market volatility in S&P 500 index options in the next 30 days, has been living up to its reputation lately as Wall Street’s preferred fear gauge.
The VIX reached a record close of 82.69 on March 16, the same day the S&P 500 dropped 12 per cent and the Dow Jones Industrial Average fell 12.9 per cent, and surpassing its last market-close peak at the height of the 2008 financial crisis.
The VIX has since fallen back to around 63, which is still well above more normal levels of between around 15-to-20 and high enough to keep many long-term investors on the sidelines.
Kash Pashootan, chief executive and chief investment officer at First Avenue Investment Counsel Inc., which manages about $1-billion in assets, watches the VIX almost hourly as a key indicator of short-term market behaviour.
“The VIX is the single most important factor of whether the markets will trade on a rational basis on fundamentals,” he said. “When the VIX trades outside of certain ranges, you can’t buy stocks based on valuation because the market is irrational … it’s mania, trading off of emotion and headlines. The probabilities are that you’re catching a falling knife when you haven’t waited for the VIX to stabilize within a certain [range].”
He said First Avenue doesn't buy equities for the long-term when the VIX is above around 30. "Until we see a stabilization of the VIX at levels closer to 30, we will remain defensive," he said. “It doesn’t mean we won’t buy equities, we will, but that’s more short-term trading as opposed to taking long-term positions."
Six weeks ago, when the VIX started to climb, Mr. Pashootan said his firm began building the cash positions in its equity portfolios from about 16 per cent to 20 per cent to about 45 per cent to 55 per cent today, “which has resulted in significant preservation of our clients’ capital. .... For us, building cash isn’t making a call on the market. We don’t view it as market timing. We view it as being defensive when the market is telling us the risk versus reward is skewed toward risk in the short-term.”
Meantime, the firm has been making some short-term trades as the VIX soared, in particular, with the SPDR S&P 500 ETF Trust (SPY).
Ron Meisels, president of Montreal-based technical analysis firm Phases & Cycles, believes after the swings in the VIX start to stabilize that buyers might want to consider stepping in.
“It’s not infallible,” he said. “It’s better if [the swings] happen five or six weeks apart. If it happens instantly, it usually doesn’t work as well.”
Ioulia Tretiakova, director of quantitative strategies at Toronto-based financial software firm PUR Investing Inc., said the VIX is one risk indicator they use to help clients determine asset allocation.
"The higher the volatility, the lower the equity holdings should be," she said, depending in part on an investor's timeline. For instance, someone with a longer investment time horizon can often afford slightly more risk.
But she cautions higher volatility can also translate into lower returns "because it's harder to compound returns." She recommends investors keep an eye on the VIX, but only as one indicator of risk.
And while the VIX is intended to be forwarded looking, Ms. Tretiakova said it’s actually a lagging indicator for investors looking for a buy signal in a bear market. Case in point is the further slide in the S&P 500 even after the VIX hit its record close on March 16.
"Using VIX to find a bottom might not be the best measure," she said. "VIX would be a slightly lagging indicator for the bottom. It will start coming down gradually after. It doesn't mean you can't use it for the long term, but for the shorter term it might be dangerous to use."
Steve Foerster, a finance professor at Western University's Ivey Business School, also cautions investors about using the VIX to time the market. "I don’t think there is any one indicator that’s a perfect predictor of any market bottom," he said. "But it's a sign of intense volatility."
He sees the VIX as more a signal that investors are uncertain of which direction the market might head, both up and down. Investors also need to be cautious when the VIX is well below its average of around 20, as it was in early January when it hovered between 12 and 13. "To me, those are times to be cautious as well," he said. "Investors not worrying about risk is also a time to worry."
Mr. Foerster said the unofficial record for the VIX was 150, reached on Oct. 19, 1987, or Black Monday, when the S&P 500 dropped by more than 20 per cent, but he notes this was before the VIX was established as an index.
“The good news is that we aren’t there, yet,” he says.