The Denial Index

The standard index and best way of measuring the volatility in the US stock market is the VIX.  (it’s an index of average implied volatility of listed options on the S&P of about 30 days expiry)

It is also known at the “Fear Index”.
But I think it should better be termed the “Denial Index”

When does VIX spike?

Volatility rises on negative shocks when stock markets drop rapidly.  This can be attributed to fear.  When the fear subsides, the stock market recovers, and the volatility drops.

This is where the index gets its name.

There are plenty of examples, take the equity market drop during 2015

Picture 1

Or the really huge drop during the financial crisis of 2008

Picture 2

The most recent sell-off also looks the same
i.e. the stock market drops and volatility rises.
So we can expect that volatility will drop again, when the market recovers.

Picture 3

If we look more closely at the examples, what we are really seeing is when there is a sharp drop in share prices, people do not believe it will last.  They do not accept that the new lower price is the correct one, and think that a rapid bounce back is likely.  What they are afraid of is that in the short term, the market will carry on going lower, but they do not expect that to last either.

In a real economic crisis, the fall in stock prices is for good reason and is here to stay.  Once the market reaches this level of acceptance, then we can have stock prices stay low, but volatility falls back to previous lower levels.  This is exactly what we saw in 2008/09.

Picture 4

If this crisis does turn out to be long lasting and real, as I currently expect, then we are still only in Stage 2  i.e. Awareness grows. Faith policy makers remains strong, even though the policy makers do not yet understand they are not in control. Markets believe it will be ok – e.g. positive reaction to Bear Sterns bail out.  (1st half of 2008)

The positive market reaction to the US stimulus package and Trump suggesting that the US be reopened is a sign that the market’s faith in policy makers remains strong.  The “Denial Index” still suggests that we expect these lower prices not to last and that a sustained recovery is imminent.  We will all find out if this faith is justified.

 

One thought on “The Denial Index”

  1. I personally believe the last leg of the equity market sell-off will come once the US completely shuts down, which is more likely than not becoming the base case. Only with that can we see equity markets recover. Just my humble opinion.

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