What is the VIX index?
The VIX index is a composite indicator of implied volatility, produced by the Chicago Board of Exchange (CBOE). It is often called the fear index as it represents the amount of variation in the S&P500 index over the next 30 days. It was introduced in the late 1980s, so the amount of historical data available is limited.
Below is the historical VIX chart since inception (source: US federal reserve) using an interactive format where you can change time frames.
You can see spikes in 1991, 1998, 2001, 2008 and 2011 as of the past few weeks. It appears that with the exception of 1998, the spikes coincided with a recession. Clearly, the Lehman moment of 2008 marked the highest climax of the past 23 years. But it also marked a buying opportunity for those who still had cash (and guts) to throw at the stock market at the time.
Why is the VIX useful?
If we assume the above observations as an indicator, then we can derive the following rule of thumb. Again, I don’t believe in exact predictors in finance. Markets very often mis-behave, as the great Benoit Mandlebrot once wrote. Consider this a heuristic approach:
- If the VIX index has been low for an extended period of time, such period being that of an average economic cycle between recessions, then the VIX is flagging warning signals. In other words, when everyone’s greedy (and skies are clear), be fearful for it may represent a market top.
- If the VIX has been elevated for an extended period of time, such period being that of an average recession, then the VIX flags bullish signals as governments typically implement stimulus to end a crisis and overpriced assets return to more “normal” prices. Figuratively, once more: when everyone’s fearful, be greedy (invest in what will survive and thrive in the next cycle).