Right now, the VIX index is saying you have nothing to worry about when it comes to the U.S. equity market.
But today I’m going to introduce you to another ‘fear’ index. And it’s telling a completely different story…
Let me explain.
The VIX has been in the financial media a lot over the past week. The VIX (or CBOE VIX Volatility Index) is also known as the ‘fear’ index. It’s a measure of anticipated market volatility.
The index is based on option prices of individual stocks in the U.S. S&P 500 index. When investors expect more price fluctuation (that is, for prices to bounce around more), the VIX goes up.
And volatility is greatest when markets fall (as the chart below shows).
As the old saying goes: The market takes the stairs up, and the elevator down.
Quoted as a percentage, the VIX is around 10. That generally means the market expects a 10 percent range of movement in the S&P 500 index over the next 30 days.
For comparison, the VIX hit an all-time high of 89.53 on October 24, 2008, in the depths of the global economic crisis.
The VIX rises when investors are surprised and scared. Investors panic-buy options to protect against further losses. As a result, implied volatility increases.
Earlier this week, the VIX closed at 9.77, its lowest level since 1993. (Note: This comes at the same time as the S&P 500 is hitting record highs.)
The VIX has only ended the day below 10 on 11 days out of 6,893 since January of 1990.
It’s fair to say that according to the VIX index, investors are less concerned about the market falling sharply in the coming weeks and months than they have been in decades.
But a different ‘fear’ index suggests that investors are being too complacent…
A different measure of ‘fear’
You’re likely to be familiar with the concept of a “black swan” event. The term was popularized by the academic and author Nassim Nicholas Taleb to describe a major unexpected market event.
It’s often an event that is heavily rationalized afterwards with the benefit of hindsight. The 2008 sub-prime crisis, the trigger for the global economic crisis, is a good example of this.
In the context of black swans, you may hear reference to something called “tail risk”.
Tail risk simply represents the probability of a black swan event occurring – that is, like a stock market crash, or a major correction.
You see, VIX doesn’t really tell us anything about how the market views tail risk (i.e. the probability of a black swan event). It just tells us about the absolute level of expected volatility.
But there’s another indicator that can. It’s called the CBOE Skew Index, or just SKEW.
This index uses the prices of S&P 500 Index options to measure the perceived tail risk of the S&P 500 over a 30-day horizon.
It does this by looking at how much investors are willing to pay for downside protection (i.e. put options) relative to upside (i.e. call options).
The more downside protection the market wants, the higher the price of put volatility relative to call volatility, and hence the higher the level of SKEW.
In other words, this index tells us how worried the market is about a near-term black swan event.
Take a look at the chart below. It shows the historical VIX index alongside the SKEW index.
The SKEW index is a messy one (I’ve used the 3-month moving average to smooth out the chart), but the trend is clear: Whilst volatility has continued to decline, SKEW is trending up.
In fact, in March of this year, the SKEW index hit its highest ever level (for the available data going back to January 1990).
This means that despite low levels of volatility, the price of put options (i.e. downside protection) is becoming increasingly expensive relative to call options.
Far from saying everything is OK, this fear indicator is telling us the opposite… that the market is increasingly paying more for downside insurance against a black swan event. So there’s more concern about it.
Does this mean that there’s going to be a sharp market correction tomorrow? No. SKEW has been trending upwards since 2008, as you can see in the chart.
However, given that it is elevated and has just hit an all-time high, it does imply that the risk of a sharp correction is rising.
What should you do? We recommend that you:
You’ve been warned!