The biggest quarterly increase ever in the Chicago Board Options Exchange Volatility Index pushed it above 40, a threshold exceeded only three percent of the time in 20 years and a level that has preceded stock rebounds.
The VIX rose 160 percent to 42.96 in the third quarter as the Standard & Poor’s 500 Index fell 14 percent, the biggest retreat since 2008, according to data compiled by Bloomberg. Closes above 40 in the volatility measure have come before the equity gauge gained 3.2 percent in the next three months on average, data compiled by Bloomberg show.
U.S. stocks posted unprecedented swings in the last three months on concern Europe’s debt crisis will spur the second global recession in three years. The VIX, derived from prices paid for options to protect equities from losses, averaged 30.6 during the quarter, the highest since 2009, according to data compiled by Bloomberg.
“A very high VIX level suggests investors have given up, they’re out of the way, and that’s a great entry point,” James Paulsen, chief investment strategist at Minneapolis-based Wells Capital Management, which oversees about $340 billion, said in a telephone interview. “It’s a contrary sentiment indicator, so when the VIX surges, it says bearish sentiment verging on panic is surging. And the market’s a good buy.”
The VIX closed above 40 a total of 166 times since it began on Jan. 2, 1990, through Sept. 30 this year, data compiled by Bloomberg show. Adjusted to group together periods when it fluctuated around that level over 30 days, the S&P 500 returned 3.2 percent in the next three months and 19 percent over the next year, the data show. The VIX rose 5.8 percent to 45.45 today.
Paulsen and Jeffrey Kleintop, who helps oversee $340.8 billion as the chief market strategist at LPL Financial Corp. in Boston, say the VIX shows that the S&P 500 has fallen too far, too fast. Companies in the benchmark gauge for American equities trade at 10.2 times 2012 forecast earnings, compared with the average in economic contractions since 1957 of 13.7, according to data compiled by Bloomberg.
Mixed signals on the U.S. economy, the American government’s loss of its AAA credit rating, and a sovereign-debt crisis that pushed government bond yields in Spain, Italy and Greece to euro-era records whipsawed equities in the third quarter, when the S&P 500 fell as much as 18 percent from its 2011 high.
The rout reflects investor concerns that governments have fewer options left to shore up growth after pumping more than $2 trillion into the global financial system. The delay in solving Europe’s sovereign-debt crisis may mean another economic slump, Deutsche Bank AG Chief Executive Officer Josef Ackermann said in a speech in Zurich on Sept. 30. European policy makers meet again on the debt crisis and averting a Greek default at an Oct. 17-18 summit in Brussels.
The VIX had its biggest three-day increase ever Aug. 4-8, closing at a 29-month high of 48. It has remained above 30 for 41 straight days through Sept. 30, the longest streak since 2009, data compiled by Bloomberg show.
“We see the VIX in the 40s as a sign the emotion in the market is extreme,” Kleintop wrote in an e-mail. “It is usually a good buying indicator when it is in the 40s.”
Basing investment decisions on the VIX’s level has led to losses in the past that were too big to justify using it in isolation, according to Doug Ramsey, the Minneapolis-based director of research at Leuthold Group. The firm oversees about $3.5 billion and recommended buying equities four days before the bull market started.
Staying Above 40
The index climbed above 40 on Oct. 2, 2008, and stayed there for three months. An investor who put $10,000 in the S&P 500 on that date would have had $9,540 in three months and $6,640 by March 3, 2009, according to total-return data compiled by Bloomberg.
“The average return calculation disguises the occasional massive loss that is just too big to stomach,” Ramsey wrote in an e-mail on Sept. 30. “With the market down 15 percent in the last couple of months and day-to-day volatility extremely high, a VIX of 40 percent is appropriate and should be seen as neutral.”
The end of September may be enough to slow losses, according to Tim Hayes, the chief investment strategist for Ned Davis Research Inc. The S&P 500 has gained a median 4.9 percent between October and December after third-quarter losses exceeding 8 percent since 1924, he wrote in a note to clients on Sept. 30.
Returns Like 1998
Volatility, data on manufacturing, and the relative performance of U.S. stocks versus global equities suggest the S&P 500 will post returns more like 1998, when it fell 19 percent between July 17 and Aug. 31, than 2008, Hayes wrote. The index gained 27 percent for the year in 1998 compared with a loss of 38 percent in 2008.
“In 1998 and so far in 2011, the respective crises in Asia and Europe did not wreak havoc comparable to 2008, when the U.S. was ground zero,” he wrote. “Today, as in 1998, the global risk is lessened by a U.S. economic outlook that appears less vulnerable than that of the crisis region, in this case Europe. And that has been reflected by the relative market performance.”
The VIX crossed over 40 for the first time ever on Aug. 31, 1998, when it reached 44.28. The S&P 500 gained 22 percent in the next three months, which also marked the beginning of a bull market in which the index added 60 percent in about a year and a half, according to data compiled by Bloomberg and Westport, Connecticut-based Birinyi Associates Inc.
VIX in 2001
When the volatility gauge rose to 41.76 on Sept. 17, 2001, the S&P 500 posted its worst daily decline in more than a year following the World Trade Center terrorist attacks and was down 21 percent for the year. In the next three months, equities rallied 9.2 percent. A year later, the benchmark gauge for U.S. stocks was down more than 20 percent for the year through September, and once the VIX reached 40.65, equities advanced 4.3 percent through the end of December.
“The VIX tells us that risk assets are oversold,” Chad Morganlander, a Florham Park, New Jersey-based money manager at Stifel Nicolaus & Co., which oversees more than $115 billion in client assets, said in a telephone interview on Sept. 30. “Investors should start layering on risk within their portfolios as this uncertainty hits a crescendo. Any type of improvement with regard to the euro zone’s debt issues would drastically lower the VIX, which would scotch the fear trade.”