The VIX is meant to measure volatility in the S&P 500 (INDEXSP:.INX), and with domestic political risk a lot higher than most people imagined would be possible, it’s being tossed around as a sign that investors are nervous about the future. But there are other, arguably better, measures of volatility that don’t show the same apprehension and are being ignored by pundits. Citi analyst Tobias Levkovich thinks that’s because the VIX is easier to wrap your head around, even if your conclusions are wrong.
“It is disappointing that so many investors discuss the VIX and accept the notion of its signaling prowess even when the back tests imply otherwise,” he writes. “Investors have higher probabilities of making money in stocks when the volatility measure [the VIX] is between 10 and 20 looking out 12 months versus buying when it is elevated to between 20 and 30. We suspect that this notion is not well understood and may surprise a great deal of people.”
The VIX measures volatility
The VIX measures volatility with a pretty straightforward—you might even same simplistic—method. It takes a weighted average of options on the S&P 500 (INDEXSP:.INX) and computes an expected, annualized spread based on them. So if the VIX is at 10 percent, that means stock prices are expected to move up or down by about 2.9 percent over the next month (n.b. simply dividing by 12 won’t give the right value). But no matter what the value is, the VIX doesn’t tell you if investors are bullish or bearish. It also assumes that options are straightforward price predictions, which isn’t exactly true.
“We see intra-stock correlation as a better metric as is the Panic/Euphoria Model not to mention Market Vane trader data,” writes Levkovich. He points to intra-stock price correlations and Citi’s proprietary Panic/Euphoria model as alternatives that currently show traders as not being apprehensive, even though the S&P 500 (INDEXSP:.INX) is down from its recent peak.
The VIX is frankly too simple to let you beat the market
Perhaps most importantly for investors and fund managers, the VIX is frankly too simple to let you beat the market. “Widely disseminated information that is perceived as simple and thereby generally understood usually does not provide the investment community with unique insight that can generate an edge,” writes Levkovich.