Stock markets go up and, as many newer investors are discovering in the turbulent start to this year, down. The frequency and magnitude of these price changes is known as volatility and the most frequently used measure for U.S. stock market volatility is the Cboe (Chicago Board Options Exchange) Volatility Index, commonly referred to as the VIX.
“The VIX is often referred to as the “fear gauge” because it spikes in times of market worries and when stocks go down,” explained LPL Financial Quantitative Strategist George Smith. “The escalating Russia-Ukraine conflict, combined with ongoing inflation and rate-hike concerns, are driving the VIX to the highest levels since 2020.”
The VIX is calculated by aggregating the weighted prices of put and call options placed on the S&P 500 index and can be considered a measure of expected 30-day volatility in the U.S stock markets.
As shown in the LPL Chart of the Day, volatility as measured by the 1-month rolling average VIX has risen sharply in the past few weeks. It spiked twice, initially in response to worries over the pace of potential Federal Reserve rate hikes and now the Russian invasion of Ukraine (as well as continuing inflation concerns).
As markets have digested the military escalation in Ukraine, the closing price for the VIX for the past two days has been close to 3 standard deviations above the 12-month average. At the January and February peaks, the VIX hit intraday highs of around 38 which if it had closed at those levels would been almost 5 standard deviation events.
Like many other measures of market sentiment that we monitor extreme levels of volatility have historically had the potential to be contrarian signals when it comes to predicting stocks prices over the short term. When the VIX has closed more than 3 standard deviations above its 12-month rolling average the forward returns for the S&P 500 have tended to be well above average, and within the 3- to 6-month timeframe have been more likely to be positive than on average. This extreme level on the VIX last occurred on 1/25/2022.
The VIX closing greater than 50% higher than its 1-month moving average has also been a reliable contrarian indicator – as long as it has occurred outside of recessionary periods – and this last occurred on 1/25 as well. The major caveat with this indicator is that we often don’t know that we are in a recession until after the fact so caution should be used considering the prevailing economic environment (which we don’t expect to be recessionary at the present time).
After an extremely quiet 2021, in which the VIX was declining throughout the year, we did expect higher volatility in 2022 as often occurs at this stage of the business cycle. However, like most of the world, outside of the kremlin, we did not expect that one of the reasons for a rise in volatility would be the largest conflict in Europe since World War Two. We do expect further market volatility as the situation unfolds and elevated uncertainty may persist for several weeks depending on how the conflict develops, but as long as the conflict is contained to Ukraine, we do not expect long-lasting contagion to broader markets. Looking back at historic geopolitical shocks stock market drawdowns average about 5% with recoveries taking less than two months, but larger conflicts in sensitive regions have led to deeper and longer lasting drawdowns.
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All index and market data from FactSet and MarketWatch.
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