Why a low VIX is nothing to fear

Key points:

• The VIX "fear gauge" has been holding around or below 17 since mid-October
• That's commonly believed to be a sign of complacency
• Testing shows that a VIX below 17 allowed the S&P to grow steadily and consistently

Drawing a "line in the sand"

The chart below shows a monthly chart for the VIX Index with the 17 level as our cutoff between implied volatility being high or not.

We will look at returns in the S&P 500 after 2 buckets:

1. When the previous day ended with the VIX below 17
2. When the previous day ended with the VIX at or above 17

Bear markets occur when VIX is above 17

From January 1990 through the present, 3,780 trading days (47%) fell into Bucket #1, and 4,271 (53%) fell into Bucket #2. Trading days following VIX < 17 readings have:

• Lower average and median daily returns
• Much lower average volatility and downside
• A slightly higher percentage of up days

Consider the statistics in the table below.

To get a better picture, the chart below displays the cumulative growth of $1 invested in the S&P 500 Index for trading days after VIX is above (blue) and below (black) 17.

Days above 17 have a higher total return, but days below 17 are overall much less volatile. The bulk of the last 3 bear markets occurred when VIX > 17.

When VIX < 17, stocks compounded in a slow, steady way

To test the argument that low VIX readings are worrisome for stocks, we will eliminate all days when VIX is >=17 and string together the performance for the S&P 500 Index only on days when VIX is < 17. 

The cumulative growth of $1 invested in the S&P 500 Index only when VIX < 17 appears in the chart below. There is a steady march from lower left to upper right. 

What the research shows…

The assertion that a low VIX reading is a warning sign to investors is misplaced. While returns may not be spectacular when VIX is < 17, they are surprisingly smooth, consistent, and non-volatile. Yes, the stock market can decline when VIX is < 17, but the mere existence of low implied options volatility among S&P 500 stocks does not appear to be a factor in creating market weakness.