The VIX is often seen as a "barometer" for measuring market panic sentiment, but the true market correlation and volatility behind it are the key factors that determine future trends.
The Chicago Board Options Exchange (CBOE) Volatility Index is one of the important indicators for interpreting market sentiment. One key reason for the recent increase in market volatility is the increased correlation between the constituent stocks of the index.
The VIX is not specifically designed as a "panic index", although it is often interpreted as such in the media. In reality, it predicts future market volatility by measuring options on the S&P 500 Index (SPX) for the next 30 days. One often overlooked factor is the correlation between the constituent stocks of the S&P 500. High correlation leads to increased index volatility, and vice versa.
Let's illustrate this point with a simplified example. Suppose there is an index composed of two stocks with equal weights. If the two stocks are perfectly correlated and both increase by 10%, the index will also increase by 10%. However, if the two stocks are inversely correlated, with one increasing by 10% and the other decreasing by 10%, then the index will remain unchanged.
In both cases, the daily volatility of the stocks is 10% - remember, volatility measures the extent of price fluctuations. However, due to the different correlations between the stocks, the volatility of the index is significantly different.
Of course, when we are discussing an index that includes 500 stocks, with different weights and volatilities, the calculation becomes much more complex. Fortunately, CBOE provides a range of correlation indices to quantify the differences between SPX and individual stock implied volatilities. Since correlations can change over time - for example, stocks with weak short-term correlations may have closer relationships in the long term - the exchange provides correlation indices for different time periods. I have found the CBOE 1-month implied correlation index (COR1M) to be very useful when compared to the VIX, as both use a similar time frame.
A rule of thumb is that correlation increases when the market declines, and decreases when it rises steadily. Considering that for most of this year, the performance of the largest technology stocks (the "Big Seven") has dominated the market, while most of the constituent stocks of the S&P 500 have lagged behind, it is not surprising that COR1M has been hovering at historic lows for most of 2024. In fact, the historical low point occurred on July 12. The VIX also reached its post-pandemic low, reaching an absolute low of 10.62, 7 days later.
However, there were some interesting phenomena at that time, perhaps a "signal". From June to early July, COR1M plummeted, while the VIX, although at a low level, remained relatively stable. As the VIX can serve as an alternative indicator of short-term hedging demand for institutional investors, it did not continue to decline like COR1M, indicating some cautious sentiment in the market. The S&P 500 peaked on July 16, although the initial decline was relatively small.
In August, the situation changed dramatically. Hedge funds suffered a brutal collapse in arbitrage trades, where they borrowed low-yielding Japanese yen to buy better-performing assets (such as technology stocks), leading to a widespread but brief sell-off. The VIX surged significantly, and the correlation also increased. When the VIX reached 65, COR1M hit a high of 76.91. However, despite the stock rebound, COR1M only returned to the 20s. Sector rotation suppressed the correlation, which also explains why the VIX remains high and has not returned to mid-year levels.
It is certain that investors are also aware that volatility may intensify in the coming weeks - a period that includes the Federal Reserve meeting and the upcoming unpredictable election. The rise in VIX is like the increase in umbrella prices when rain clouds appear, and correlation can be seen as a barometer.