The VIX Can Predict Recessions: The VIX Rule of 26

The VIX can signal recessions. The VIX, or Volatility Index, is a widely recognized measure of market volatility, often referred to as the "fear gauge." It reflects the stock market's expectations for volatility over the next 30 days, specifically tied to the S&P 500 index.

The VIX is derived from the prices of S&P 500 options and provides an indication of how much the market expects the index to fluctuate, both up or down. A higher VIX value suggests increased uncertainty and a greater expectation of price swings, signaling potential economic instability or heightened investor fear.

The VIX is currently near the range that would predict a recession, without Fed action. The most recent VIX closing value, as of September 6, 2024, is 22.38. Using this value, I can calculate the predicted percentage decline in the S&P 500 over the next 30 days:

Predicted S&P 500 Decline = [22.38/12^(1/2)]?3.29 ≈ 21.28%

This means the VIX suggests a potential 21.28% decline in the S&P 500 over the next 30 days, assuming no offsetting action by the Federal Reserve and/or a positive real shock. This figure also reflects the expected proportionate decline in the US Nominal GDP growth rate.

One might object that a VIX prediction should be interepreted as +/- 21.28%, and that’s true, but it tends to rise with respect to fear of losses in the market, and in my view reflects a predicted loss, if nothing material changes.

Notably, this recent VIX quote is near a figure above which would predict a recession. You can call this the “VIX rule of 26”. A VIX at a bit over 26 corresponds to a predicted 25% decline in the S&P 500 within 30 days, ceteris paribus, and hence a 25% decline in NGDP growth. This assumes expected quarterly NGDP growth is a simple average spread over 4 quarters, and uses a z-score of 3.29, which represents 99.9% confidence.

Historically, while not every rise in the VIX above this level has preceded recessions, all recessions since 1990 have followed the VIX rising above this level.?

Note that the Great Recession was not a continuous recession, as the economy dipped into a mild recession in late 2007, recovered into slow growth, and then plunged negative in late Q3 and in Q4 of 2008 and early 2009.? Also note that 1990 is the earliest date for this VIX data.

I want to emphasize again that all economic forecasts are conditional, subject to change given news, which represents "shocks" or surprises. The volatility in the S&P 500 options market is currently telling us that the Federal Reserve needs to loosen monetary policy, or face a serious economic slowdown soon, save unforeseen positive material devleopments.