U.S. stocks are about to cap off their worst year since 2008. But investors wouldn’t know it by glancing at what’s often referred to as Wall Street’s favorite fear gauge, which has recently failed to reach new heights as stocks tumbled to fresh lows.
The Cboe Volatility Index
better known as the VIX, is on track to finish 2022 not far off its long-term average despite widespread pain across markets. The VIX, based on trading in S&P 500 index options, serves as an indicator of expected volatility in the index over the coming 30-day period.
After topping out at 36.45 on March 7, it repeatedly failed to make new highs for the year, according to data from FactSet, even as stocks tumbled to their lowest levels in years in June and again in September and October.
Nicholas Colas, co-founder of DataTrek Research, highlighted the phenomenon in several research notes to his clients this year.
Not only is the S&P 500 on track to finish the year down roughly 20%, 2022 has also been the most consistently choppy year for stocks in more than a decade by at least one measure.
The index has recorded 46 moves of 2% in either direction since the start of the year, the most since 2009, according to Dow Jones Market Data — narrowly surpassing the number from 2020. That’s roughly four times the 10-year average of 11.3 per year.
The VIX fell 3% on Thursday to 21.46 in afternoon trading as the S&P 500
Dow Jones Industrial Average DJIA and Nasdaq Composite COMP all headed for daily gains after the Nasdaq booked its lowest closing level of the year on Wednesday.
A ‘really terrible year’
Perhaps counterintuitively, Colas and others see the subdued VIX as a potential cause for concern. This is because a spike in the fear gauge has typically preceded stock-market bottoms in recent decades.
Colas and others refer to the phenomenon as “capitulation,” meaning that a surge in the VIX means that sentiment in the market has grown so dire that the beginning of a market turnaround is likely at hand.
The VIX surged above 80 before stocks bottomed out in March 2009, and again in March 2020. Colas has said in the past that levels above 40 are needed to signal that capitulation is at hand. Volatility typically rises fastest when stocks are falling, market strategists said.
The lack of a clear signal that bears are reaching a point of exhaustion has made some analysts wonder if the market’s lows might still lie ahead.
“Volatility seems too low,” said Danny Kirsch, head of the options desk at Piper Sandler, during a phone interview with MarketWatch this week. “I’d say the VIX should be in its mid-to-high 20s, as opposed to barely 20.”
“We had a really terrible year. There was massive wealth destruction, and yet the cost to hedge going forward hasn’t really changed,” Kirsch added.
Is the VIX ‘broken’?
Comparing the VIX’s 2022 performance to 2008 recently led Michael Kramer, founder of Mott Capital, to conclude that the gauge may be “broken” in a tweet published on Wednesday.
Others have pushed back against this notion, arguing that while the VIX has been “somewhat low,” it’s still elevated compared with recent market history.
To wit, the VIX’s current level is still more than twice its record low from Nov. 3, 2017, when the volatility gauge closed at 9.14, according to data from FactSet. This occurred at a time when U.S. stocks were drifting consistently higher. The S&P 500 went on to finish 2017 with a gain of more than 20%.
“It’s been a high VIX year, just not as high as some people think it should have been, given volatility elsewhere in markets,” said Rocky Fishman, the head of index volatility research at Goldman Sachs Group Inc.
The VIX has also maintained its strong inverse correlation to the S&P 500, as Callie Cox, a U.S. equity analyst at eToro, pointed out. Data shared by Cox showed that the VIX has moved inversely with the S&P 500
roughly 80% of the time since its inception in 1990.
Why so low?
So, why has the VIX been so subdued? Cox, Kirsch and others rattled off several factors that might be contributing to its malaise.
One popular explanation is that as institutional investors dumped stocks and shifted more of their portfolios to cash this year, they were left with smaller levels of long-equity exposure in need of hedging.
“VIX is basically a measure of demand for hedges by the biggest investors in the market. But when institutional investors are liquidating their equity positions, they no longer have a need for the associated hedges, so they unwind those positions in the derivatives markets and ultimately that pressures” the VIX, said analysts at Sevens Report Research in a note entitled “Is the VIX broken?” published earlier this month.
Also, a generally bearish outlook for markets means that institutional investors are “fairly well hedged,” Kirsch said, which helps keep a lid on the VIX when large selloffs materialize.
Others cited traders’ increasing reliance on short-term options for tactical trades.
While the VIX is designed to interpret increased options buying as a sign that investors are growing more anxious, it specifically incorporates only options with roughly one month left until expiration.
This has become an issue as trading in shorter-dated options, including contracts with less than one day left until they expire, has surged in popularity this year, according to data from Goldman Sachs.
Trading in zero-day to expiration S&P 500 options has surged in the fourth quarter to more than four times its average level from 2021, according to data shared by Goldman in a research note dated Dec. 15.
“The VIX doesn’t accurately measure fear these days because there’s so much trading in short-dated options,” said Steve Sosnick, chief strategist at Interactive Brokers.
Is a blowup looming?
The question for investors now is whether a subdued VIX might lead to a volatility-inspired reckoning for markets, like what happened in February 2018, when a popular short-volatility trade rapidly unwound, contributing to the death of short-volatility products like the VelocityShares Daily Inverse VIX Short Term ETN.
It’s possible that markets could undergo a volatility-driven “washout” as some of the trades helping to suppress the VIX are unwound, Kirsch said. Although he doesn’t expect the impact on markets to be as severe as it was in 2018 or 2020, he told MarketWatch.
But whatever happens, it’s possible analysts who rely on the VIX to inform their trading might need to adjust their expectations around what constitutes a capitulation signal, Cox told MarketWatch. Still, this doesn’t necessarily mean that the VIX is “broken.”
“It’s still measuring what it’s intended to measure,” she said. “This is more a story of how much the options market has evolved over the past few years.”
“People just aren’t using classic one-month options to hedge or speculate as much. Investors are choosing to get more precise with their options strategies, which makes a lot of sense — it’s cheaper and more adaptable,” Cox added.