The return of the VIX to a low-to-medium volatiliy regime, favorable to equity markets
Volatility is a structuring indicator of financial markets and at the same time an instrument that is actively “traded” in trading rooms, with upward and downward strategies.
The best-known barometer for analyzing this volatility is the VIX index based on the S&P500 while in Europe, the VStoxx based on the Euro Stoxx50 or VDAX based on the Dax, are the most frequently used in stock trading room.
The VIX represents the annualized "implied volatility" of the S&P 500 that helps investors estimate how much the S&P 500 will move over the next 30 days. The calculation is based on S&P 500 short-term options traded on the CBOE (Chicago Board Option Exchange). If market makers expect high volatility, which may be linked to current or future events (elections, wars, central bank decisions, etc.), the premiums on these options will be higher and more costly for the market traders. When market makers expect low volatility, which is the case in bull markets, the premiums on these options will be lower and less expensive. When stock indexes reverse to the downside, options premiums typically skyrocket and the VIX accelerates upward.
A clear correlation between the VIX level and the S&P500 trend
Certain levels of volatility indices are also indicative of the market phase. Historically, the stock market does not perform well with a VIX above 20 and there is a high correlation between the VIX and the S&P500.
The chart below show the strength of the correlation between the VIX and the S&P500 over 10 years.
It should be noted that correction periods like 2020 and 2022 are marked by a VIX which spends most of its time above the level of 20 (above the red line), with differences in the volatility regimes. We can clearly distinguish the stock market panic linked to Covid-19 pandemic with a VIX at the peak, as well as the market correction linked to the acceleration of the rise in rates in 2022 where the VIX fluctuates, in both cases, between 20 and 30 most of the time.
When the S&P500 enters an upward trend, the VIX remains below 20 with variations between 13 and 20 as we experienced in 2023 - apart from the peak in March at the time of the SVB and Crédit Suisse banking crisis.
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During long-term uptrends, the VIX spends most of its time below 20 with a few occasional spikes in volatility. The phases where it settles at lower levels (below 13) are rarer and correspond to markets in a regular bullish regime, as was the case in 2013, 2014 and especially 2017 with a sharp increase in the number of bullish/bearish days.
Currently, major indices appear to be entering this zone again, which has several implications. The first being that the markets are closing the highly volatile parenthesis linked to Covid-19 and its direct effects on (a) the supply chain, (b) the surge in inflation and (c) the rise in interest rates (2020-23) . The second is that the change in volatility regime (VIX regularly below the threshold of 20) confirms the return to a long-term upward trend for the S&P500. This does not mean that there will not be new episodes of volatility and peaks above 20 - therefore impulses and corrections on the indices -, but it means that the markets have regained visibility.
With Phiadvisor Valquant's MPI indicator, one can determine the different stock market phases
Phiadvisor is interested in the volatility regime (to be distinguished from the spot reading of the VIX regardless of its amplitude), in order to distinguish phases favorable and unfavorable to the stock markets. Our proprietary Market Pressure Index (MPI) indicator was built with this in mind and gives us an understanding of the stock market risk according to the following:
The MPI is currently in a favorable zone for stocks (< 50) after going through a neutral phase throughout September and a surge for a few days above 60 in mid-October. The MPI returned to a favorable zone for equity markets from November 6th onwards.
Some investors adopt so-called “contrarian” strategies when the VIX is in a low zone, as it is currently the case, by buying the volatility, or conversely by selling the VIX if it exceeds 20. Our research leads us to only have a “contrarian” attitude in extreme cases, that is to say returning to the equity markets despite very high volatility, only if our MPI indicates a culmination/capitulation point which happens very rarely, the last time being on March 20, 2020.
?For the remainder, our strategy remains to align with the volatility regime. Today it is clearly favorable.
Lionel Pellicer, Phiadvisor Valquant partner