This spooky season, fear is everywhere.
In your house, under your bed, behind that door, and in the markets you’re investing in.
But according to some analysts, there may not be enough fear out there. Their take: the VIX — the stock market’s classic fear gauge — could be signaling that the bear market isn’t over, simply because it’s not high enough.
It’s a strange observation, mainly because we all know the vibes are pretty anxious at the moment.
Maybe we’re not afraid enough about what’s to come.
Or maybe we’re simply misunderstanding what fear looks like.
A history of fear
The VIX, a measure of supply and demand for S&P 500 options over the next month, is a fascinating way to gauge the market’s mood. The thinking is that if people are afraid of the future, they’ll buy more options to protect their portfolios (or hedge).
Over the years, the VIX has done a decent job at keeping tabs on the market’s fear. Since its inception in 1990, the VIX has moved in the opposite direction of the S&P 500 on 76% of days. Again, it checks out: stocks fall, fear rises.
In market crises, a spike in the VIX has historically been an early clue that a selloff is almost over. In the past four bear markets, the VIX has peaked an average of two months before the stock market turned around. During the Global Financial Crisis, the VIX soared as high as 81 in November 2008, four months before the S&P 500’s March 2009 bottom. Fast forward to the COVID crisis, and the VIX shot up to a record high of 83 on March 16, only a week before the bottom.
Wall Street calls this capitulation:the moment when the pain becomes too great to bear. And typically, a high VIX and capitulation go hand in hand.
How fear has changed
Not this time around. The VIX hasn’t spiked yet, even though this year has been one of fear and pain for portfolios. The VIX’s high point this year? 36, on March 7, when the S&P 500 was three months into the selloff. Today, the bear is almost 11 months old, the S&P 500 has dropped as much as 25%, and the VIX is just below 30.
Some think the issue is that investors aren’t scared enough. But if you stop and think about what the VIX actually measures, this becomes a story of how investors are expressing their fear.
Let’s get one thing straight: Investors are appropriately anxious, but they’re reacting in a way we haven’t seen before. Instead of buying blanket protection through monthly options, they’re opting for weekly and daily options to hedge around events: Fed days, inflation data, and jobs reports, for example. By my count, about 32% of S&P 500 options that expire this year are daily or weekly options.
People are getting smarter and more precise with their money because they have the tools to do so. It makes sense, too. If you’re worried about a Fed decision and have the ability to position around it, wouldn’t you rather buy a short-dated option than potentially pay more for an imprecise hedge? It’s like fighting a vampire with garlic and stakes, instead of a chainsaw.
Still, the focus on short-term hedging has blunted swings in the VIX, especially on days you’d expect there to be more fear. This year, the VIX has been the least sensitive to S&P 500 moves of 1% or more since 2013. In other words, stocks are swinging, but the VIX itself isn’t moving.
However, the near-term VIX — a similar index that measures supply and demand in options expiring in the next nine days — is moving noticeably more, especially around important events.
Fear or surprise?
This year has been painful, but not necessarily surprising.
There’s a difference, friends. You’re probably going to scream louder if you’re not expecting that monster to creep up behind you, right?
Yes, some headlines have caught us off guard (like one country invading another). But for the most part, this bear market hasn’t been much of a surprise. Inflation has been an issue for the past several months, and the Fed has been hiking rates since March.
It’s been an excruciatingly slow burn of a selloff, but in a weird way, the pessimism may be keeping stocks afloat.
When investors are expecting negative headlines, they’re more likely to prepare for a selloff before it hits (instead of everybody selling at once). When this happens, the VIX doesn’t spike— it just stays elevated for months. Compare that to the last two bears, when a financial crisis and a global pandemic rocked the world. Lots of fear and surprise, and thus, a soaring VIX.
Nic Colas, one of my favorite market analysts, compares this environment to a Hitchcock horror movie — one where your nerves are on edge the entire time — versus a teenage slasher movie, in which one moment scares you off your couch.
A healthy dose of fear
Talking about the market’s mood can be a rabbit hole, but it’s important to understand how the market’s mood could impact its actions.
A fearful market isn’t something to be afraid of, either. This bear has forced investors to think about their risks for 11 months straight. People are pessimistic, but strength in parts of the economy is proving them wrong, and that’s why we’re seeing unusually strong bursts of buying on hints of good news.
And in a broader sense, it’s crucial not to lean on your priors. History often rhymes, but the investing landscape is changing faster than some of us can comprehend. Think about the context behind classic market indicators like the VIX before you bank a strategy on them.
*Data sourced through Bloomberg. Can be made available upon request.