October 2nd, 2008

Does VIX Inform or Mislead?

Don’t let anyone tell you otherwise. Today’s market action was frightening. The S&P 500 again violated where I estimate might be a support trendline; with what is expected to be a bad jobs report tomorrow morning and the House’s vote for the bailout, the odds are that the market will continue its cascade to lower levels.

But I need some help. I have been hearing and reading recently that we must be close to the bottom because the VIX is over 40 and getting this high each time “coincides with being close to the bottom”. I’m sorry, I don’t see it that way.

A couple of days ago, Barry Ritholtz, a blogger I admire and respect, wrote “Readings of 50+ are rare and obviously mark extreme panic. Assuming you have cash and know what you’re doing, it’s probably not a bad time to buy good companies”. He included the following chart:

So did some research and overlayed the VIX onto the S&P 500 during the Tech Bubble Market Crash of 2000-03 to see whether the VIX above 40 actually presaged a market reversal. This is what I found:

Four times over the three years, the value of the VIX exceeded 40. Subsequent to each of the first three occurrences, the market bounced for a couple of months but, several months later, it was signficantly lower (the dark line is the VIX and the light line is the S&P 500 Index; the S&P 500 scale is the right furthermost). Only when the VIX hit 50 or more did the market actual begin building a bottom.

Based on what I’ve seen, the VIX is a crude instrument and may be good at anticipating a short-term bounce but, until it hits extreme values (50 or more), it gives false indications that a bottom has been reached. Today, the VIX closed at a value of 45.26. I wouldn’t bet that we’ve touched bottom yet; a bounce perhaps, but not a bottom.

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