This week’s chart takes a closer look at the VVIX, also known as the “Volatility of Volatility Index.” The index measures the expected volatility of the 30-day forward price of the Volatility Index (VIX). The VVIX is known to be one of the best proxy measures of tail risk – the likelihood of an event that has a very small probability of happening, but has huge implications once it occurs.
Since the financial crisis in 2008, the VVIX has fluctuated. For example, it spiked when the market was rocked by major adverse events such as the Lehman Brothers bankruptcy, U.S. credit rating downgrade, European debt crisis and Brexit referendum. After a 10-year boom, the stock market dropped in December 2018, volatility jumped and fears spread about the end of the cyclical expansion. In these circumstances, we expected that the VVIX level would jump as well, but it actually bottomed out. Why?
A strong U.S. economy could be the reason. As long as earnings are strong enough to justify the high valuation of the stock market, a big drop offers a nice buy-the-dip opportunity. Moreover, all major economic indicators support the strength of the U.S. economy, so the likelihood of the tail event is naturally low. In this case, markets were jittered by fears of a recession, but did not change the expectation of the tail risk.
Market complacency, however, makes a stronger case. We experienced an extremely low level of VIX in 2017, and that low level ended with the sudden breakout of volatility in early 2018. Because of this, it is possible that complacency kept the VVIX artificially low in December 2018. Additionally, we have plenty of sources for tail risks, such as policy and political uncertainties, government debt, the trade war with China and the slow recovery of other developed economies.
VVIX is a good indicator of the tail risk in the market, but it might have been underestimated in late 2018. Investors should take a closer look at the VVIX for a possible breakout in 2019. The breakout can be associated with some materialized tail risks that were not fully priced thus far.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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