1/8/2016

IstheExtremeVIXDiscountCauseforConcern?Schaeffer'sInvestmentResearch

IS THE EXTREME VIX DISCOUNT CAUSE FOR CONCERN?

What to make of a massive VIX discount

Stocks quoted in this article: SPX | VIX
8/1/2016 8:26 AM
The following is a reprint of the market commentary from the August 2016 edition of The Option
Advisor, published on July 21. For more information or to subscribe to The Option Advisor-featuring 10 new option trades each month --click here.
If the summer months once had a reputation as a period of sleepy, soporic action in the stock
market, the post-nancial crisis era has ushered in a new regime. The trading in 2016 has been
no exception to this new normal, with wild extremes in both stock prices and market
volatility occurring in recent weeks -- creating plenty of fodder for analysis by technicians,
sentimenticians, and market historians alike. But when investors are treated to dramatic
uctuations in major market benchmarks every other week, how much value can be derived
from these signals -- and how much is just "noise"?
Take the CBOE Volatility Index (VIX) discount of 40.5% clocked at the July 20 close, marking this
metric's most extreme reading since the current record of 42.5% was set in November 2008. The
VIX discount, for those unfamiliar with the concept, reects the dierence when the spot VIX
declines below the 20-day historical volatility of the S&P 500 Index (SPX). In other words, a "VIX
discount" means that short-term S&P options are pricing in lower volatility expectations for the
month ahead than that which the index has actually realized over the last four weeks' worth of
trading (as compared to a "VIX premium," which reects the degree to which spot VIX is
"overpricing" S&P historical volatility).
From a sentiment perspective, one might conclude that a VIX discount -- and, in particular, a
multi-year low VIX discount -- reects a potentially dangerous level of complacency among
investors. After all, if traders aren't prepared to encounter the same degree of volatility which
the stock market has so recently experienced, aren't they especially vulnerable to a negative
surprise?
In many respects, this logic is quite sound. As contrarians, we prefer to see a healthy amount of
skepticism and uncertainty levied against the market, as this suggests there is still buying power
left to sustain additional upside (whereas a complacent, "what could possibly go wrong?"
attitude tends to occur just before market tops). And for those who fear that the current VIX

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IstheExtremeVIXDiscountCauseforConcern?Schaeffer'sInvestmentResearch

discount is pointing to just such a risky situation for stocks, with downside shocks very possible
during the short term, it will be reassuring to point out that the current "VIX discount" situation
means that it's an opportune time to purchase portfolio protection in the form of put options.
But a look back at prior VIX discounts of similar magnitude won't do much to reassure those
who may be concerned that investors are overly complacent. Going back to 2002, there have
been four occasions where the VIX discount arrived at negative 35% or lower, with the most
recent such signal occurring earlier this month (to avoid any "clutter" in this data set, we
considered only one signal per 20-day period). Looking at the average returns following these
signals, the S&P is down by nearly 4% one month later, with only one positive return in the
bunch. That compares quite negatively with the S&P's average "anytime" one-month return of
0.5% since 2002 (and comparisons over various other time frames are similarly ominous, per
the table below).

Even more troubling, if we look at the returns following the November 2008 VIX discount
extreme that was just approached, the S&P was trading down by roughly 16% one month later.
And four months after that signal, the S&P's loss had widened to nearly 33%.
But before we load up on gold bullion and head for the bunker, let's add some valuable context
here: The VIX discount signal in November 2008 followed on the heels of the VIX's October 2008
spike to all-time highs, triggered by the nancial crisis that threw the banking sector -- and all of
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Wall Street -- into massive turmoil. In somewhat similar fashion, the VIX jumped last month in
the wake of the "Brexit" vote, with the resulting market turmoil briey resulting in a VIX premium
north of 200%.
In this regard, the extreme VIX discounts of both November 2008 and July 2016 were, to no
small extent, the result of traders readjusting their volatility expectations back to "normal" levels
in the wake of substantial event-based shocks to the market -- even as these shocks remained a
lingering factor in S&P historical volatility calculations. Unless it's your belief that Brexit has
materially changed the fundamental outlook for U.S. stocks for the worse, it's reasonable to
assume that the current VIX discount is more or less a blip in the math at this point, rather than
an omen of steeper stock losses to come.
And let's not forget that historical returns following prior VIX discount signals are based on an
extremely small number of prior occurrences, which somewhat diminishes the usefulness of
this data set as we attempt to determine the stock market's next potential move. Plus, as noted
in the latest Monday Morning Outlook, the latest such signal occurred against the backdrop of
the S&P trading atop its 200-day moving average amid lingering skepticism on the sentiment
front. With the current VIX discount extreme accompanied by an otherwise contrarian bullish
technical and sentiment setup, and no doubt triggered by the extraordinary fundamental
circumstance of the Brexit vote, it may be safe to classify this latest signal as "noise," instead of
cause for pushing the panic button on stocks.
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Article by
Bernie Schaeer

2016 Schaeer's Investment Research, Inc.

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