The Truth About Vix Shrinkage

Everyone’s talking about the incredible shrinking Vix, Wall Street chief strategists included. 

The below from Nicholas Colas, ConvergEx Group chief market strategist, on Friday…

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A few points on the history of the VIX here:

• The close yesterday at 14.3 is the third lowest of the year and near one standard deviation away (6 points) from the long run average of 20.

• Contrary to popular opinion, August is actually not the dullest month of the year, at least according to the 22 year history of the ‘Fear Index’.  That distinction goes to December, when in 7 of those 22 years the VIX actually saw its bottom for a given calendar year.  Only in 2000 was the low volume, vacation-prone August the month where the VIX bottomed for the year.

• September and parts of the fourth quarter of any given year do, on average, see an increase in the CBOE VIX Index, meaning that investors grow more concerned about the direction of the market once Labor Day is in the rear view mirror.  The average August VIX reading since 1990 is 20.84, but the average September VIX registers at 22.17. That is an average increase of 6.4%.  There isn’t much further progress through the fourth quarter on average, and December more often ends with a whimper, as I have noted.

• Historical volatility –the amount by which stocks actually move (rather than the VIX, which measures expected movement) has collapsed in recent days.  The 10-day actual volatility for exchange traded funds which track the S&P 500 is around 10.7%, which makes a 14.29 VIX actually look kind of rich.  As in the VIX may have more to fall in the coming days, since near term price action is essentially at near record lows as well.

The most logical question is “What gives?” – aren’t we supposed to be days away from financial Armageddon over the survival of the euro, the resolution of the “Fiscal Cliff,” a contentious and expensive campaign season, a weakening Chinese economy, and scores of other maladies?  The short answer is that we are, but I am reminded of the famous quote from St. Augustine: ‘Given me volatility, but not just yet.”  OK, his sentiment was about the ability to live a celibate and honorable life.   But you get the idea.  Using the VIX to measure every type of expected volatility is like using a thermometer to diagnose a gunshot wound.  We will see higher volatility.  At some point.  The VIX is mute on when, and that is by design.

In practice, the VIX measures expected changes in stock prices over the next 30 days.  That’s it.  It is heavily informed by recent actual volatility, as I noted.  A VIX reading of 14 shouldn’t make anyone, anywhere, feel more confident about what will come down the road in October or beyond.  It is simply the relative assurance that the weather will be clear tomorrow.  Volatility, like the weather, changes with the seasons and other factors.  And even if you are sleepwalking, it is wise to take an umbrella.

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Source:

ConvergEx Group