Observe this chart:
This is the iPath S&P 500 VIX Short Term Futures TM ETN, a fund that serves to track changes in the VIX, the volatility index sometimes called the “fear indicator”. The VIX is a macroeconomic indicator that tracks, through a measurement of futures activity, market expectations of a bull or bear market. The VIX is inversely proportional to stocks, meaning that it tends to go up as stocks go down (and vice versa). This isn’t always the case, because you can have volatility with rising stock prices, and they are not directly proportional—a 10% spike in the VIX will not mean a 10% decrease in stock prices. Still, they are closely correlated enough that a following of the VIX will give you a sense of investor expectations.
For the past month, the VIX has hit very high levels, relative to recent history. The VIX is actually down over 70% in the past year alone as volatility has dropped further and further. There are a number of reasons for this trend, and we encourage you to read this, this, and this (all pieces currently in Zolio’s Learning Center) to understand the historical context of the VIX’s current movements.
Going forward, investors should try to understand why the VIX has gone up lately and to what extent this movement can be expected to continue.
It is no news that the Federal Reserve is contemplating an end to its bond-buying program that is the most recent bout of Quantitative Easing. Such a move would generally mean that it would cost more to borrow money, which would raise costs for institutional investors. It would also mean bond rates would go up, causing people to move money out of stocks and into bonds. Both implications of an end of QE are bad for stocks. This has caused fear, and fear has meant bear days that put the VIX upward.
Wednesday saw the VIX go down, even as stocks fell too. But the stock drop is very small, and is much less than most investors expect—as of Wednesday afternoon, the Dow Jones was down less than 0.35%. More importantly, some bad economic data has lead a number of investors to conclude that the Federal Reserve will not end its QE program soon. This is an interesting paradox. The bad economic data usually means lower stock prices, but in this case Federal Reserve intervention means bad economic data will temporarily raise stocks by flooding the market with cheap money that allows investors to stay in stocks.
But bad economic news is still bad, so stocks are hardly going to rally on the data. Thus we have flat to slightly down stocks, while investors bide their time. This means some selling, but not a lot.
And that, in turn, means less volatility: the market on Wednesday has decided that it knows what is going to happen. Bernanke is going to announce that the bond-buying program will not be tapered off anytime soon, and investors can stay in equities and out of bonds. Thus the fear of a big sell off is down, and so is the VIX.