Is the Extreme VIX Discount Cause for Concern?

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, soporific action in the stock market, the post-financial 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 fluctuations 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, reflects the difference 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 reflects 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 -- reflects 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 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 financial crisis that threw the banking sector -- and all of 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 briefly 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.