What Do Rising Correlations Signal?

Just when everyone expected that volatility would never come back, early last month, we saw a massive spike in Cboe’s Volatility Index, or VIX, known popularly as the “‘market’s fear gauge.” Timing markets is never easy, and a spike in the market’s fear can rarely be predicted with complete accuracy, but does it mean investors should liquidate and divest their portfolios?

Below are highlights of events from February 5 and what generally technical signals imply for investors looking ahead.

A Jump of Historic Magnitude

I have been consistently writing on why investors should not be complacent about low VIX levels and why it is important to look at both historical and realized volatility. On the second trading day of last month, February 2, we noticed a peculiar trend in which realized volatility, after staying low for a long time, accelerated more than implied volatility, thereby compressing spreads. What happened on the next trading day, February 5, was truly remarkable:

VIX and the S&P 500 are generally negatively correlated; therefore, it is normal for VIX to jump when the S&P 500 declines. However, a 20-point jump in VIX is something that deserves special attention here.

Until February 5, since the inception of VIX in March 1990, a jump as high as 20 points by VIX in a single day had NEVER happened. To put it in perspective, the S&P 500 over the same period had 32 days with 4% or more declines, but on none of those days did VIX jump as much. Under a normal distribution, this was a 5 standard deviation move with a likelihood of 0.002%. Thus a 4% decline by the S&P is rare, but a 20-point jump by VIX is extreme.

The exhibit below shows the relationship between S&P daily returns and VIX daily changes. Looking at the historical relationship, VIX daily changes have had a beta of -1.12 to S&P daily returns. This simply means that a 4% decline in the S&P 500 should have meant a jump of roughly 4.48 points in VIX. However, VIX jumped about 4.5 times more!