The CBOE Volatility Index, aka the VIX, is a pretty weird metric in the financial markets.
Volatility isn’t exactly quantifiable because you can’t observe it directly. However, options gurus figured out that you can derive it from options prices.
An option offers the option holder the right to buy or sell an asset within a set period of time. Already, that agreement includes several easily observable and quantifiable variables including the current price of the underlying asset, the exercise price, the time the option expires, and therefore the risk-free interest rate for that period. The price of the option factors in those variables, but also includes a premium to account for potential swings in the price of the asset. That premium captures volatility, which allows us to price the VIX. Because volatility is calculated indirectly, most people call it implied volatility; it’s implied by all of those other variables.
The VIX, aka the “fear gauge,” got a lot of attention during and after the financial crisis because it exploded when the markets crashed, and it tumbled as the markets rallied.
However, it’s important to note that the VIX and the market don’t always move in opposite directions.
Indeed, in the late 1990’s, they surged together.
Charles Schwab’s Liz Ann Sonders thinks we could see a repeat of that in coming years.
“Stress in [the emerging markets] has been a contributing factor behind the recent uptick in volatility, but I believe we may be entering a period similar to the mid-to-late 1990s, when the stock market and volatility both rose for an extended period (the only time in history). As most know (and you can partly see in the chart below), the two generally move inversely,” she wrote in her recent commentary.”
Here’s a chart of the 12-month moving average of the VIX Sonders provided. Notice the shaded area.
Sonders bulleted some other similarities she has already observed between today and the late 1990s. Here they are verbatim:
- Post-financial crisis period (S&L crisis then, housing crisis now)
- Slow, “jobless” economic recovery
- Similar stage within economic cycle
- Extremely easy monetary policy, but “normalization” beginning
- Low inflation
- Freer trade (NAFTA then, WTO pact now)
- Today’s eurozone = 1990s Japan
- Government shutdowns (1995-1996 and 2013)
- Midterm election year (1994 and 2014)
- Rapidly improving federal budget deficit
- Minimum wage hike
- Technology revolution
- Rising valuations from depressed levels
- US market outperforming emerging markets (EM)
- Record-high margin debt levels
- Rising volatility
- Increasing equity mutual fund inflows
Read Sonders’ whole comment at Schwab.com.
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