Tuesday, February 20, 2007

The SPX:VIX Relationship

After giving it fairly prominent play over the past few months at Technically Speaking, Ron Sen asks whether the SPX:VIX ratio chart works effectively as a risk metric.

Many people seem to be giving up on the VIX lately, but the SPX:VIX ratio is a special case. Part of the problem with this ratio is that it compares one trending number with another one that oscillates. Using Ibbotson data as a guide, we can assume -- over the long term at least -- that the SPX should return about 10% per year, while the VIX should oscillate around a stable mean. Interestingly, if you add a 10% trend line to the SPX:VIX ratio chart going back to 1991 in order to compensate for this, you will discover that 15 ½ years later, the trend line almost perfectly bisects the current Bollinger bands.

If you study the chart for a little longer, some interesting conclusions emerge:

  • except for the latter half of the dot com crash and the Asian financial crisis, the SPX:VIX ratio has rarely strayed far from the values predicted by the 10% trend line
  • since 2004, the SPX:VIX ratio has hugged the 10% trend line very closely
  • the current deviation above the trend line is matched only by mid-2000, early 1994 and late 1995 – three periods that turned out to be the beginning of a deep bear, a mild bear and a strong bull market

I think the SPX:VIX ratio is indeed a useful risk metric, but I recommend using it in a manner that compensates for the long-term bullish bias in stocks and/or that focuses largely on the relative peaks and valleys.

At the moment, I think the SPX:VIX ratio is flashing a mild warning sign, but ultimately where you come down on the ratio is probably more dependent upon what you think about reasons for the historically low VIX than the historically high SPX.

40 comments:

Ron Sen, MD, FCCP said...

Good stuff, Bill.

Thanks.

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