By Nicholas Hamner
Investment Advisor Representative
[email protected]
If it exists, people find a way to measure it in some way. But that measurement doesn’t always stay the same. Take distance.
King Henry I declared the yard to be the distance from his nose to this thumb. Today, a yard is standardized at 36 inches. What is an inch? The inch was originally determined by measuring three barleycorns end to end, but is now standardized as 25.4 millimeter’s. What is a millimeter? 1/1000th of a meter. What’s a meter? Nothing, what’s a-meter with you? Originally, a meter was the length of a pendulum that took one second to complete its arc, then it became one ten-millionth of the shortest distance from the North Pole to the equator passing through Paris, and now it is a specific number of wavelengths of light measured in a vacuum using scientific measurements that merit more explanation than I have the space to flesh out. Let’s just say “Science!” and move on…
But for all the legitimate measurements out there, there are plenty of illegitimate ones. News organizations give you rankings all the time about “happiest countries” and “hardest partying schools” using dubious measurements. All the new digital wearables out there give you all sorts of data—your sleep score, your heart rate variance, optimal times for workouts, etc.—that medical professionals will take one look at and completely disregard. Questionable measurements of questionable data.
That in mind, let’s talk about the VIX.
You’ve probably seen the VIX referenced anytime there’s a conversation about shakiness in the market. It is technically the Chicago Board Options Exchange’s CBOE Volatility Index, a measurement of assumed fear & volatility in the market. It’s a relatively recent creation, all things considered, originating in the late 80s by two researchers who went through numerous iterations of their measurement model before they settled on the “Sigma Index” which ultimately became the VIX we know today. At its root, the VIX measures/estimates the stock market’s expectation of volatility over the next 30 days by analyzing the prices of S&P 500 index options, rising as the cost of hedge options rises. When investors pay higher premiums for the options to hedge against potential losses, it signals increased market uncertainty and anticipated price swings.
I know anytime I use a word like “options” or “puts” or “hedging”, the attention span of anyone reading this disappears. So… let’s use the same principle on something a little closer to home.
It seems like every weekend there’s a prediction of 10”-12” of snow. Most of the time, it doesn’t snow so we train ourselves to ignore the risk. We don’t even buy eggs or bread. But if one day you’re standing in line at Ace and you start to see a run on shovels, snowblowers, generators, and salt… and people attempting to outbid one another for the last ones… you start to take the risk more seriously because you see more people are fearful of a big snowstorm coming in.
Hedging options are available all the time in the market. But when investors start buying them more frequently and the price of those options goes up, the VIX goes up. The VIX is not measuring costs over time, it’s using those fearful purchases and the price people are willing to pay for them as a proxy for how worried those same people are about market volatility.
At its core, the VIX is measuring legitimate data. So then the question becomes, “Is the VIX a reliable indicator of market performance?” Asked another way, “If the VIX goes up does that mean the market will go down?”
To flesh this out, let’s assume a 5% rise in the VIX is what we’d pay attention to, and a drop in the market is a downward movement of 1.5% or greater, and the two would correlate if a market drop occurred within five trading days of the VIX spike. Under those criteria, per my digging on the Internet, the market has dropped within a week three times out of every 10 times the VIX has spiked. Those are better odds than getting struck by lightning or catching a foul ball at a major league game, but they are far less accurate a predictor than… say… a weather forecast. And even if we up the ante by making the VIX spike 10% to be considered significant, it’s still only correlating to a downward market event four out of every 10 times.
So is the VIX measuring real data? Yes. Is the VIX an indicator of market sentiment as it relates to fear? Possibly. Does that fear translate to market drops? Sometimes. Is it a reliable indicator of market movements? Probably not… if your car only cranked 30% of the time, you wouldn’t call it reliable.
Should you trust the VIX at all? About as much as you trust your watch to tell you how well you slept.
So why does the media report on the VIX at all? You click their links, don’t you?