The CBOE Volatility Index (VIX) hit 12.50 yesterday, close to the lows achieved just prior to the latest market correction in August 2015. Examining the relationship between the VIX Index and the less familiar longer-dated CBOE 3-Month Volatility Index (VXV) can provide investors with useful insights in forecasting future changes in equity prices, bond yields and market volatility. Like the VIX, the VXV is a measure of expected volatility in the S&P 500 that is computed from the prices of options on the index. However, while the VIX measures one-month implied volatility, the VXV is designed to be a constant measure of 3-month implied volatility of the S&P 500. In other words, the VIX-to-VXV ratio provides a simple instrument to evaluate the one to three month S&P 500 implied volatility term structure.
A high reading in the VIX-to-VXV ratio tends to coincide with panicky markets where short-term fear can get high enough that the VIX Index will sometimes reach higher levels than the value of the VXV Index. Considering that this indicator exhibits strong mean reverting tendencies, such market behavior historically tends to provide equity investors with attractive entry points. This last occurred on February 11th when the VIX-to-VXV ratio closed at 1.02 and a strong rally in global equities ensued with the S&P 500 up close to 15% since.
Conversely, a low reading in the VIX-to-VXV ratio often coincides with high investor complacency where market participants expect much lower volatility over the next thirty days compared to the coming three months. This is often a precursor to bearish equity market action. Interestingly, yesterday’s close below 0.80 in the VIX-to-VXV ratio is at the bottom-end of its historical trading range and may signal that the equity market might have become gradually, one again, too complacent over recent weeks (see the chart below). Although it might be interesting to ride the current wave of optimism, it might also be prudent to start building cash positions to take advantage of market pullbacks which, according to this model, have a high probability of occurrence.
We have studied historical changes in the VIX-to-VXV ratio over the past ten years and their past implications for forward changes
in equity prices, bond yields and market volatility. Historically, when the 20-day moving average in this indicator closed below the 0.82 level, the equity market tended to provide negative returns over the following three months (see the table below). In addition, the U.S. 10-yr bond yield tended to decline and market volatility was on the rise over the following three months.
The bottom line is that even if we remain positive about stock market perspectives longer terms and still expect equities to hit new record highs in 2016 as global economic growth should pick up, interest rates will remain low for an extended period and corporate profits should gain traction with a strong rebound in energy prices during the second half of 2016, we are noticing that key sentiment indicators are approaching extreme positivism and we believe that market conditions point to a less favourable environment for investors. A topping in the relative performance of cyclical against defensive sectors as well as the NYSE cumulative advance/decline line, which have not occurred yet, would only reinforce this view. Investors should also closely monitor coming developments in credit markets as a widening in corporate spreads often tends to lead market pullbacks or corrections. A pick-up in the CBOE Options Equity Put/Call ratio would also represent an additional precursor to bearish equity market action.