IWM - The Collapse Of The VIX: Why Now You Should Be Worried

2023-06-23 12:03:28 ET

Summary

• Just yesterday, the VIX hit its lowest level since January 2020.
• A defensive stance does not necessarily mean exiting the market.
• I said all along that I though mid-June would be the set up for a potential risk-off period.

Life is being on the wire, everything else is just waiting. - Karl Wallenda.

The CBOE Volatility Index, popularly known as the VIX or the "fear index," is a key barometer of market sentiment and certainty. It's a real-time market index that represents the market's expectation of 30-day forward-looking volatility. It is derived from the price inputs of the S&P 500 (SP500) index options and provides a measure of market risk and investors' sentiments. It opens a window into the collective psyche of investors, offering insights into their risk appetite and fear levels.

Historically, the S&P VIX Index (VIX) tends to spike during periods of financial turmoil, reflecting increasing investor fear, doubt and risk aversion. Conversely, a falling VIX typically signifies a bullish market environment marked by investor complacency and appetite for risk.

Recent Movements in the VIX

Just yesterday, the VIX hit its lowest level since January 2020. This collapse in the VIX has coincided with a rally in U.S. large-cap equities, including growth tech names and mega-cap stocks ( QQQ ). This, while inflation is still raging, at the same time we are in the seasonally weak period of May to October for stocks.

Implications of a Low VIX Environment

A low VIX environment is often misconstrued as a green light for aggressive risk-taking. However, this is a dangerous assumption. The complacency signaled by a low VIX can quickly give way to volatility, leading to a market "accident." This is because the VIX is mean-reverting - it tends to spike back up after hitting historically low levels.

Consequently, a low VIX environment calls for caution rather than complacency. It is a period when investors should consider adopting a defensive stance, because no one knows when the VIX will spike, but we do know that the likelihood of a VIX spike is higher when the VIX's starting point is already low.

Adopting a Defensive Stance

In light of the heightened risk of a market setback, investors should consider tilting towards low-beta sectors like Utilities ( XLU ), Consumer Staples ( XLP ), and Health care ( XLV ). These sectors tend to be less volatile than the overall market and may provide a buffer against market downturns.

A defensive stance does not necessarily mean exiting the market. Rather, it involves repositioning the portfolio towards assets and sectors that are expected to hold up better during market downturns. Defensive sectors not only offer the potential for risk mitigation but also provide opportunities for returns. They enable investors to stay invested in the market while offering some level of protection against sudden market downturns. They also allow you to be wrong (meaning stocks keep rising and volatility remains muted) while still giving you a chance to make money while wrong.

Note that this would NOT be the case if you directly tried to buy a long VIX ETF like ProShares VIX Short-Term Futures ETF ( VIXY ) because there's no way to actually buy spot VIX, resulting in a constant bleed of price unless you happen to get a VIX spike perfectly when initiating a position, and then sell it perfectly after.

The Perils of Short VIX Futures

In a low VIX environment, some investors might be tempted to use exchange-traded funds like the ProShares Short VIX Short-Term Futures ETF ( SVXY ) that short VIX futures. However, these products can be highly risky. They are susceptible to sudden losses if the VIX spikes. Timing these products can also be challenging, making them a less than ideal choice for investors looking to navigate a low VIX environment, on top of the bleed that comes from the continuous rolling over of futures underneath the ticker.

The 2020 Dow Award: Sector Positioning and VIX Levels

The recent movements in the VIX and their implications for investors bring to mind the findings of my 2020 Dow Award-winning study on sector positioning and VIX levels. The study highlighted the effectiveness of a defensive positioning strategy during periods of low volatility as measured by the VIX.

The study argued that positioning into defensive sectors during periods of low volatility and into cyclical sectors during periods of high volatility could generate significant long-term alpha. This strategy was found to outperform a passive buy-and-hold approach, underscoring the efficacy of using mean reversion to generate alpha.

Conclusion

The recent collapse of the VIX is a reminder of the cyclical nature of markets and the need for investors to remain vigilant. A low VIX environment should not be viewed as a signal to increase risk-taking. Instead, it should be seen as a call for defensive positioning, as it often precedes a spike in volatility.

I said all along that I thought mid-June would be the set-up for a potential risk-off period. We'll see if I'm right on the outcome, but all of my indicators are beginning to see a storm coming. How it plays out is the challenge, which is why how you express your trade is critical.

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