The stock market's "fear gauge" is pacing for its lowest average close in history
As of now, 2017 is on pace to have the lowest average daily CBOE Volatility Index (VIX) level ever (we have VIX data back to 1990). You can see the average VIX level by year in the chart below. Since 1990, the average VIX close has been just below 20, but this year, it's just 11.55. That beats the previous lowest average of 12.39 in 1995. Hopefully, my analysis this week will give us some insight into what this rare VIX signal means for the stock market in the second half of the year.
In case you’re not familiar with the VIX, it uses option prices on the S&P 500 Index (SPX) to calculate the expected volatility over the next 30 days. It is often referred to as the stock market's "fear gauge," because it tends to spike when the market falls. Therefore, the currently low VIX in 2017 could be interpreted as investors being complacent and not expecting an imminent sell-off. So far, they have been right, but what are the chances of this calmness lasting through the second half?
First-Half VIX & Second-Half Stock Returns
The table below shows how the SPX did in the second half of the year, dependent on how low the average VIX was in the first half. Going back to 1990, I grouped the years into three brackets depending on the average VIX level in the first half of the year. There were nine years of returns in each bracket. Then, I summarized the return for the S&P 500 Index in the second half of the year.
The low-VIX years, like this year, correspond with the best stock returns in the second half, when measured by average return. In these years, the SPX averaged a 5.92% gain in the second half, compared to an average return of 4.92% in moderate-VIX years, and just a 1.86% gain in years where the VIX was high. Interestingly, the median return in low-VIX years is the lowest of all years.
The strong point of low-VIX years is in their consistency. The standard deviation of second-half S&P returns is lowest in these years, with the average loss being less than 2%. Based on this data, you could conclude there's a good chance of a decent second half for the stock market, with a low probability of a big loss (though I'd prefer more data points than nine returns per bracket to have strong conviction in that conclusion).
Low VIX Begets Low VIX
The last table shows some first-half and second-half data for the low-VIX years. A low VIX in the first half of the year usually leads to a low VIX in the second half, with a major exception being 2007, when the market topped out just before the financial crisis. The years of 2013, 2014, and 2015 all had a low average VIX in the first half of the year. The second-half returns for the S&P 500 Index range from about a 1% loss in 2015, to a 15% gain in 2013, while 2014 saw a 5% gain.
One promising observation is that neither of the two market crashes since 1990 occurred in a year when the average VIX reached a low. The tech bubble popped in 2000, and you can see from the first table in this article that the VIX bottomed out in 1995, but rose in the next few years before the crash. The VIX reached a very low level in 2005 and 2006, and then moved higher in 2007. The market topped out in 2007, but the bulk of the losses occurred the following year in 2008.