The Striking Price

A New Vision of VIX

STEVEN M. SEARS

Saturday, August 16, 2014

A Goldman Sachs study suggests that investors may no longer fully understand the fear gauge.

Over the past 21 years, the CBOE Volatility Index, or VIX, has emerged as one of Wall Street's most watched sentiment indicators.

VIX's predictive powers are so highly valued that investors who never trade options check the VIX each day to understand how sophisticated investors view stocks over the next 30 days.

When the VIX is low, it is time to go, the old saw goes. When the VIX is high, it's time to buy. This simply means that when the index is at a low level – the long-term average is about 19 – investors are too complacent about stocks, and equities may soon decline. But when the VIX is high – and it peaked at about 90 during the worst of the credit crisis in late 2008 – it is a sign of widespread investor fear, which tends to precede stock rallies. The stock market began a historical rally after the gauge peaked during the credit crisis.

But this standard view of the VIX may no longer be entirely correct, explaining why so many investors have complained this year that the measure is broken or sometimes disconnected from the market's realities.

After all, the VIX has spent much of the past year at relatively subdued levels, and the stocks have continued grinding higher, setting new records, despite widespread worries that investors are too complacent or somehow missing the larger picture.

A recent Goldman Sachs study suggests that the VIX is not really broken but that investors no longer understand entirely what motivates the fear gauge.

Most investors view the index as a reflection of investor sentiment captured by the implied volatility levels of various bearish puts and bullish calls on the Standard & Poor's 500 index. That is true, but Goldman's research suggests economic data are a more powerful volatility determinant than VIX-specific determinants.

Krag "Buzz" Gregory, a Goldman strategist, found that U.S. consumer spending, manufacturing, and employment data explain 57% of the variability in VIX levels back to 2000.

In a recent note explaining his study, Gregory told clients that the options market is engaged in a tug of war between a strengthening U.S. economy and menacing geopolitical concerns. Against this battle between the constructive and destructive, the VIX has averaged 16.3 in August, versus a year-to-date average of 13.7.

"While risk-off sentiment driven by rising geopolitical risk is a concern, fundamentally our models are pointing to lower realized volatility and VIX levels," Gregory wrote. "We expect VIX levels to decline over the course of August."

Goldman's study suggests that the VIX should average 12.5 for August. When the study was released last Monday, the index opened at 15.16 and closed at 14.23. By week's end, it was right around where Gregory said it should be.

GOLDMAN'S STUDY emerges as BlackRock, the world's largest asset manager, is saying that volatility should be considered an asset class like stocks and bonds. Critics disagree. They say volatility is simply something created by the rise and fall of stocks and other assets.

But this increasingly quantitative approach epitomized by Gregory's research, and widely favored at BlackRock, suggests that the old ideas about volatility will be enhanced by new analytical methods. This probably presages a greater acceptance among investors of the idea that volatility is an asset class.

In the meantime, investors are advised to think more broadly about the VIX. Rather than just comparing the VIX's undulations with stocks, be mindful of how VIX and the market respond to economic data.

Reprinted by permission of Barron's Online, © 2014 Dow Jones & Company, Inc. All Rights Reserved Worldwide.

The views expressed in the above papers and articles are solely those of the author of the article, and do not necessarily reflect the views of OIC; the information presented is not intended to constitute investment advice or recommendations to purchase or sell securities of any company; and the information presented is based upon particular events that may or may not recur in the future.

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