The VIX index has almost doubled since the start of January. There seems to be an obvious interpretation: growing fear – of higher inflation, higher interest rates, stagflation or perhaps recession. In short, fear of falling securities prices. Present levels are way below those from the pandemic spring of 2020, but clearly above the average over the last eight years before the pandemic.
This index has an intriguing feature: It is designed to be forward-looking. It represents market expectations of the next month's volatility, hence the Fear Index moniker. The official name is the CBOE Volatility Index; VIX is the ticker code.
Calculation of the VIX is based on market prices of calls and puts on the S&P 500 for the following month. Option values rise with increased volatility, but as option investors can't measure future volatility, we talk about implicit volatility. In other words, we can glimpse their expectations through observing what they do.
So ... what's their hit rate? What does this index tell us about the future?
I 2003 the VIX was tailored to the S&P 500. In the following years it actually turned out to be a good estimate of future volatility, having a correlation with next month's volatility of 0.7. I dare say that's a good fit. The figure would have been zero if there was no fit whatsoever.
We must remember, however, that this is derived from trade between human beings who are, unarguably, affected by the present sentiment and recent events. We see this clearly if we calculate the correlation with the preceding month's volatility: 0.9! For all practical purposes, these series go in lockstep.
To wit: The fear measured by this index is primarily the fear already embodied in current stock prices. And the seemingly good estimate of future volatility may just as well be described as a result of autocorrelation in the volatility series.
As market declines tend to be swifter than rising markets, this manifestation of fear is typically evident when stock markets fall. If you allow a bit of simplification: A rising VIX index really only tells you that stock prices have fallen. Every time we get a correction or a crash, the VIX index spikes.
This is just another way of saying that when stock prices dive, investors get scared. How surprising is that?
