Stocks suffered through their first meaningful pullback of the year over the last month, as the S&P 500 fell nearly 10% from a mid-July high to an August 5th low. The depth of the fall wasn’t unusual; the S&P 500 has averaged an intra-year decline of 14% since 1980. But a panicky 3% drop on August 5th concerned many investors. Fortunately, that large single day drop marked the end of the decline and the market has since rebounded strongly. As of this writing, the S&P 500 is just 1% below its all time high reached last month. And while there are always reasons to be concerned, one key indicator suggests the August 5th low was the bottom in the market for the foreseeable future.
The VIX as a thermometer
The VIX is a volatility index that measures the expected move in the S&P 500 over the next 30 days. In simpler terms, the VIX tells you how much investors expect the market to swing around. A high VIX means investors expect big swings, a low VIX means investors expect small swings. Higher VIX levels are associated with periods of market stress, such as the 2008 Financial Crisis or the 2020 Covid Crash. Lower VIX levels are associated with relatively steady markets.
The best way to think of the VIX is as a thermometer reading, where very high VIX levels suggest the market might be sick. We can contextualize this by pointing out that the VIX often rises and stays high during periods of market stress. You might say that the VIX “gets sticky” at high levels when it is identifying a potential illness. In comparison, VIX spikes that come right back down are associated more with one-off panics that don’t lead to major market declines.
The VIX has a long-term average of 18.18. Notice in the graph above that the VIX has had plenty of spikes over the years, with the largest ones occurring in 2008 and 2020. Where the VIX goes isn’t very telling though, rather, it’s more about where the VIX stays.
The VIX spiked towards 30 in 2007 and stayed above its long-term average the entire year. Throughout 2007 the VIX was “sticky” at high levels. This precluded a serious drop in stocks in 2008 as the Global Financial Crisis unfolded. As a temperature gauge, or thermometer, the VIX correctly identified an illness in the market a full year ahead of time. The VIX was also sticky at elevated levels beginning in 2022 and stocks fell 25% that year.
Other VIX spikes in 2010, 2016, 2018, and 2019 all quickly came back down. Even in 2020, when the VIX spiked significantly, it came down pretty quickly. And while Covid affected the entire world for much of 2020-2021, it really only mattered to the stock market for a 30-60 day stretch from March-April 2020. The stock market actually finished with solid gains in 2020.
The VIX says everything is fine
This latest pop and drop in the VIX is in line with other drops that occurred during market uptrends. On August 5th, the VIX hit a high near 40 after being under 20 the week before. That is a dramatic rise in the VIX. However, just two weeks later, the VIX had fallen more than 60% back to 15. This is the fastest decline in the VIX ever recorded (data since 1990). Looking at similarly fast declines shows forward returns for the S&P 500 have been above average (data from Charlie Bilello):
This is exactly the type of VIX action that is associated with one-off panics or normal market pullbacks (we classify drops of 10% as “normal”). If the VIX was identifying a major fundamental issue in the market (ergo economy), we would have expected the VIX to easily stay above its long-term average. In other words, because this VIX spike didn’t “stick” at elevated levels, it suggests the market bottomed on August 5th. Should the VIX quickly move back over 20 in the coming weeks, that would be reason for concern. At the moment, the market doesn’t appear to be sick.
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