Opinion: VIX Indices Show How Stock Investors Undervalued Coronavirus Pandemic Risk
The speed of the fall in the stock market and the increase in market volatility over the past month has been astounding.
Since its highs in mid-February, the S&P 500 SPX,
is currently down around 25%, while the CBOE VIX volatility index,
, an indicator of stock market volatility, peaked at an all-time high of 83. On April 2 trading, it finished at around 51.
Has the market underestimated the risk of a real coronavirus pandemic?
A major clue suggests that the market was indeed behind in assessing the risks posed by a pandemic. The index comes from the somewhat obscure, but heavily traded, VIX futures market. The VIX is a widely followed indicator of market volatility, and the VIX futures market is akin to a market for predicting the future position of the VIX.
As a starting point, it seems reasonable to question whether the markets were fully aware of the risks of the coming pandemic before this all started. On February 19, the S&P 500 closed at a record high just 14 points below 3400. The VIX closed around 14; a value that was, like most days during the bull market in previous years, well below its historic average of 20.
These events occurred even though the first U.S. case of the COVID-19 coronavirus was reported in mainstream media and confirmed by the CDC on January 21. The news from China had been disastrous; on February 12, the media reported 14,000 new cases in Hubei province alone.
On March 2, coronavirus cases were skyrocketing in Europe and the United States had reported possible community spread as well as its first coronavirus-related death. The S&P 500 had then fallen to just under 3100. The VIX had meanwhile risen to 33, certainly a big increase from 14. But did this reflect a full appreciation of the growing risks in the market?
On March 2, with the VIX at 33, the futures contract expiring on March 18 settled at a futures price of 26, suggesting markets were expecting the VIX to drop 7 points over 16 days. The VIX tends to predictably move towards its long-term average – let’s call it 20 – so even though things got worse later, the forecast of 26 at the time didn’t seem unreasonable.
But because the VIX tends to get closer to its average, we should ask ourselves: on March 2, with the VIX at 33, where a statistical model would place the VIX on March 18? Using well-known techniques that I discussed in a 2019 article published in the Review of Financial Studies, a statistical model estimated using VIX history would have produced a forecast of just over 30.
Both predictions turned out to be far removed from reality: things quickly got worse. The VIX hit around 70 on March 18. Since the futures price was lower than the statistically correct forecast, investors expected volatility to decrease from the correct forecast.
The key observation is that the futures price has fallen below the correct forecast. It’s usually the other way around: the futures price usually exceeds the VIX’s fair forecast. The reason is that a trader who buys a VIX futures contract covers higher uncertainty and therefore pays a higher price than fair. Instead, with prices below fair expectations, investors in the VIX futures market were behind schedule in gauging just how bad things would turn out to be.
Read: Stock market might not bottom until the VIX drops – here’s why the volatility gauge remains stubbornly high
Investors weren’t just lagging behind the March 2 forecast. As the chart below shows, as of February 24, futures prices have fallen below the contemporary VIX statistical forecast for more than two weeks. Crucially, futures prices tend to rise after such days. This suggests that investors were overly optimistic about the decrease in volatility.
This type of pattern is not just due to chance or a bad statistical model, but rather an under-appreciation of growing risks in the market. In the Review of financial studies article, I document that throughout the history of the VIX futures market, futures prices tend to fall below statistically correct forecasts as market risks increase, but there is nonetheless a tendency for futures prices to approach the correct forecast thereafter. Most notably, VIX futures prices fell below fair expectations on the eve of episodes covering a thug’s gallery of major market turmoil such as the 2008 financial crisis. Even in these episodes, prices futures then adjusted upward as investors realized the looming risks.
Investors in the VIX futures market have been slow to appreciate the growing risks to the market as the coronavirus pandemic spread. This period of undervaluation seems to be over: VIX futures prices are now exceeding statistical forecasts. Just a few weeks ago the market didn’t think the uncertainty would last that long, but now there are signs that the market expects it to be with us for some time.
Ing-Haw Cheng is Associate Professor of Business Administration at Tuck School of Business at Dartmouth College. This comment is not investment advice.
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