Sunday, October 31, 2004
Click on the picture for a bigger chart.
This is a chart of the Volatility Index going back to its inception. Much has been made about the low level of the VIX for the last couple of years. VIX measures volatility of options on the S+P 500 index. This is often used as a contrary indicator. A low VIX is said to mean complacency exits in the market and so the market may drop when VIX is low. Conversely the market may rise when VIX is at a high level. Barron's has fixated on how low the VIX is. Actually it is not that low. If you look at the chart you see that it has spent half of its life below 20, like it is now.
The time spent above 20 occurred when technology, a relatively volatile group, had a record weighting in the index. Keep in mind that the S+P 500 is capitalization weighted. During the bubble days tech grew to become 30% of the index. Juniper Networks, Yahoo!, JDSU, Broadcom, the old AOL and a couple others I am forgetting had market caps greater than $200 billion. So all that giant volatility was embedded into the price of SPX options back then and the VIX traded between 20 and 40. Now that these stocks are a fraction of their former value and the tech weighting in the S+P is in the teens it only makes sense that VIX has been below 20 for quite a while.
Tech alone might account for a lower VIX but the other thing holding down the VIX is low interest rates. The risk free rate of return an investor can get from a Treasury Bill goes into every type of options pricing model that I have ever heard of. Generally speaking lower interest rates will reduce option prices, everything else being equal. The conclusion here is that it may not make sense to think VIX is low by comparing it to 1998-2002.
Posted by Roger Nusbaum at 8:43 AM