How to Interpret and Navigate the Markets During Times of Increased Volatility

The Cboe Volatility Index (known as “VIX”) measures the market’s expectations for volatility over the next 30 days, expressed through weighted S&P 500 index options.
When investors are worried, option premiums and, consequently, VIX usually rise, reflecting increased uncertainty.

A very high level of the index often signals panic or extreme fear. Such spikes sometimes suggest that the market may have overreacted, potentially creating buying opportunities. The problem with using VIX as a buy or sell signal is that while sometimes fears are exaggerated, sometimes they are not.

For example, during the so-called “Taper Tantrum” in 2018, during the first 10 days of October, the S&P 500 index fell by more than 6.7%, while VIX doubled from around 12 to around 25. However, this did not turn out to be an exceptional buying opportunity, as the S&P index lost almost another 14% to its lows in December.

A VIX level in the 20s indicates that the market is scared, but not in panic. A VIX around 22 is approximately in the 72nd percentile—above average, but not extreme.

So what constitutes an extreme level?
To put VIX levels into context, I divided them by decades. On the chart below, the x-axis represents the corresponding decades. 0-10 is the lowest decade—the group with the lowest 10% of all VIX observations, while 90-100 is the highest decade, the highest 10% of all VIX observations. The columns represent the average return over the next 30 days. So, when the market is extremely calm, the lowest decade, the average 30-day return ahead is 0.72%. The average return for the second decade is 0.8%, and so on. As of Wednesday’s close, VIX is in the 71.5th percentile for all data, corresponding to the 70-80th decade on the x-axis of the chart. As you can see, the average return for the S&P 500 over the next 30 days is just 0.07%, significantly below the average 30-day return for all data of 0.81% (the straight blue line). This “group” represents VIX levels between 21.59 and 24.28.

Does this mean that the market will have below-average returns over the next 30 days?
Not necessarily, but it is a dangerous zone when considering several other factors. One of them is valuation. While valuation is not a tool for timing the market, much above-average valuations add extra risk. The S&P 500 is trading at a 25-30% premium over the average multiple of future earnings over the past 35 years. Secondly, VIX is trading at about a 25% premium over the average value of the last 30 days.

Why is this important?
Volatility is a mean-reverting process, meaning it is much higher than the average level for the last month, which shows that it is currently moving away from the mean. If the previous 30-day average VIX was higher than the current level, it would mean it is reverting to the mean. When we include these additional factors, where the current VIX level is higher than the 30-day moving average and the future PE is above 18, the average return over the next 30 days is -0.73%.

This type of data analysis can be unclear because the more filters applied, the scarcer the data becomes. Over the last 35 years, only 219 trading days, or 2.47% of the data, meet these criteria.