NEW YORK, Feb. 5, 2018 — A trader works at the New York Stock Exchange in New York, the United … [+] States, on Feb. 5, 2018. U.S. stocks closed sharply lower on Monday, with the Dow plummeting 4.60 percent, as the market took a heavy hit from panic sales. (Xinhua/Wang Ying via Getty Images)
Big spikes in stock market volatility are really scary, and oftentimes, it comes with the added fear of economic uncertainty. During this time, investors are running for the hills, worried about their jobs and their assets.
In these instances, stocks suffer from a trio of negatives: They’re liquid, they’re volatile, and they’re risk-on assets. Put another way, they’re easy to sell when things get tough.
When investors feel like times of trouble are on the horizon — or at the front door — many tend to dump these assets in an effort to protect their hard-earned capital. Unfortunately, selling when everyone else is selling is often a mistake for long-term investors, but it happens because our emotions take over.
Volatility Goes Up When Stocks Go Down
When it comes to the stock market, volatility is often viewed through the CBOE Volatility Index — formally known as “the VIX” and informally referred to as Wall Street’s “fear gauge.”
It’s not a perfect nickname, but it’s fairly accurate for conversational purposes.
That’s as the VIX tends to go up when stocks are going down. However, it’s not a direct correlation to the value of the S&P 500. Instead, it’s based on S&P 500 options pricing. We won’t get into the weeds on it because it’s not all that important for most investors, but according to the CBOE, “The VIX Index is a calculation designed to produce a measure of constant, 30-day expected volatility of the U.S. stock market, derived from real-time, mid-quote prices of S&P 500® Index (SPX) call and put options.”
It’s important to note that the VIX is a measure of expected volatility, not direct volatility.
Monthly performance of the S&P 500 from 1998 to 2021, showing spikes in the VIX above 48. Source: … [+] eToro, Bloomberg.
The VIX is often on the rise when bad things are happening in the economy, like the Covid-19 pandemic and the financial crisis. But sometimes, it’s more a function of volatility-specific products or VIX-related mechanics rather than a larger macro issue.
Regarding the latter, two events quickly come to mind: The “Volmaggedon” situation in 2018 and the unwinding carry trade in August 2024. Both incidences occurred amid an otherwise solid macro backdrop, but wreaked havoc in the volatility markets.
At this point you might be thinking: “I don’t care about volatility products! Why does the VIX or volatility even matter to me?!” Well, let’s find out.
When Volatility Zigs, It’s Time to Zag
Whether the VIX is spiking because of market mechanics or macro-related issues, investors should consider their options carefully.
When the VIX has historically large surges — like the one-day spikes of 40% or more highlighted in the table below — the knee-jerk reaction for stocks is generally a selloff. However, that selloff can help set up a solid long-term performance for the S&P 500.
One-year forward returns for the S&P 500 when the VIX spikes by more than 40% in a single day.
In that table, notice how well equities have performed a year later, with the S&P 500 up more than 90% of the time following these VIX spikes. The average return in this scenario is an impressive 18.1%.
Further, when the VIX finally falls significantly, it can also point to favorable returns for the S&P 500. In fact, one-day declines of 20% or more in the VIX are met by an S&P 500 win-rate of more than 83% when looking one year down the road.
One might argue — like we have — that the long-term annual win-rate for the S&P 500 sits just below 80% and that the statistics regarding swift declines in volatility aren’t that meaningful.
The counter point to this rationale is that investors can measure volatility and the S&P 500 with a spreadsheet, but it’s much harder to track real-time trends in emotion. Put another way, it can be difficult to feel like the odds are in investors’ favor when volatility is screaming higher and stocks are rolling over.
History may not repeat, but it often rhymes.
The catalysts driving stock market volatility may change between market cycles, but knowing how prior instances from those extreme times resolved could pay off when we inevitably see them again in the future. While past circumstances can’t predict future outcomes, knowing how the odds shift in times of turmoil can help ease the emotional burden around our investment decisions.
