US Markets

One of Wall Street's favorite ways to time the stock market may not work at all

Key Points
  • The CBOE Volatility Index almost always falls when the market rises and has little predictive power, Wells Fargo analyst Scott Wren said.
  • Traders lately have worried that a VIX hovering around all-time lows is indicative that the market has become too complacent and a downturn is ahead.
UBS CEO: Not even discussing bad volatility in this environment
UBS CEO: Not even discussing bad volatility in this environment

One of Wall Street's favorite indicators of fear is actually of little use when trying to look into what the future holds for stocks, according to one analysis.

Traders often cite the CBOE Volatility Index as a reliable indicator of what's ahead. The VIX is a measure of options contracts and is supposed to provide a window into what the market will do over the next 24 to 36 days.

Lately, market watchers have fretted that low readings are pointing to a market that is overly complacent. That, they argue, is a reason to believe that a sudden jolt to psychology could send stocks tumbling.

However, investors need to realize that the VIX actually has little predictive abilities and is more just a measure of where the market stands on any particular trading day, Scott Wren, senior global equity strategist at the Wells Fargo Investment Institute, said in a note to clients.

"History also helps investors understand the limitations of using the VIX as a gauge of where the market might be going," Wren said. "In this strategist's opinion, based on historical analysis, the VIX is a coincident, not a leading, indicator."

Indeed, the index and the market generally move in opposite directions. When the has risen, the VIX has fallen 82 percent of the time, according to historical data. Here's a look at the past five years using FactSet data [the blue line is the S&P 500 and the green is the VIX]:

"In other words, the VIX is a gauge of how the market feels right now — at this instant," Wren wrote. "When the S&P 500 is trading meaningfully to the downside on any given day or series of days, the VIX typically jumps higher in response."

Just a recent history of VIX spikes shows that the index has been not very good at predicting what the market would do in the near term.

It spiked above 20 on Nov. 4, just a few days before the presidential election, indicating a market downturn. However, a month later, the S&P 500 was up 5.8 percent. The VIX also saw a spike on April 13 that preceded a rally, then jumped again on May 17 only to indicate yet another market surge.

Conversely, in times of apathy, when the index plunges, there's been little indication of a market collapse ahead. In fact, the index has been well below its all-time average just below 20 for most of 2017, a year in which the S&P 500 has notched a more than 9 percent gain without a significant downturn or correction.

"The biggest moves [up] in the VIX happen on days where the S&P 500 sells off aggressively. In the current market environment, where the major indices have crawled to new highs over a period of months characterized by narrow ranges and low trading volumes, one would expect the volatility portion of an option's price to be low," Wren said. "The recent level of the VIX simply reflects our current environment."

A representative of the CBOE did not immediately respond to a request for comment.

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