Markets are hard to predict right now, and that's raising a question for some on Wall Street: Does a common measure of volatility actually work the way it should?
Traders don't have a crystal ball to measure the level of risk when they make investment decisions. Instead they depend on the VIX, or the Chicago Board Options Exchange Volatility Index.
Known as Wall Street's "fear gauge," the index is supposed to reflect the market's estimate of future volatility — or how fast prices will change — 30 days out.
An elevated VIX means increased fear and risk, while a low VIX means the market is entering a less stressful period. That's why the VIX tends to move in the opposite direction of the market.
But as investors churn through increasingly choppy markets, some analysts are worried that this trusted measure of forecasting is broken. The gauge, they say, doesn't work in an atmosphere heavy with uncertainty, which is when traders most need it.
The VIX is worthless in forecasting the direction of stocks, Aaron Anderson, senior vice president of research at Fisher Investments, told me.
"There's just no correlation to future returns," he said. "We've never understood why so many people accredit so much to the VIX."
Markets have tumbled over the last four days, bringing the recent late-summer comeback into doubt. The VIX is just now catching up to that, and only sort of.
Digging in: Thirty is considered a high benchmark for the VIX. The index floated around 20 and below — which would indicate less volatility — for most of August. It hit 25 on Wednesday.
In theory, if the index were to predict future market moves, it would have risen that high ahead of last week's selloff, Scott Bauer, CEO of Prosper Trading Academy, who worked for 15 years as a market maker at the CBOE, told me.
Cliff Asness of AQR Capital Management agrees that the index has limited utility: "The VIX tells us almost nothing beyond how much markets have been bouncing around lately," he wrote. In an analysis dating back to the 1990s, he found that the VIX was essentially in line with the S&P 500.
By the time an investor looks back and determines a VIX peak or trough, said analysts at Fisher Investments, they've likely already missed the corresponding turn in the S&P 500.
Sometimes there isn't any connection at all. Fisher analysts pointed to 1995 — a stellar year for markets that had no correlation to the VIX.
The index wasn't designed to be as useful to retail investors as it is for institutions, said Bauer. There's a whole cottage industry of derivatives built off it. When the CBOE first created the VIX in 1992, it was intended to be a way for traders to make money by predicting market volatility. It wasn't supposed to become the major fear gauge it is today.
The bottom line: In uncertain times, we like to cling to any future reassurances that we can, and the financial media certainly likes to use the VIX to that end. But when the unknowns are unknown, the VIX tends to break down.
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