Markets

The Curious Relationship Between Stocks and Volatility

By Adam O'Dell  |  October 2, 2018

The first three quarters of 2018 are now officially in the books.

It’s been a weird year, right?!

The increasingly unconventional circus in Washington, and the discomfort it’s causing both domestically and abroad, has kept just about everyone in a constant state of anxiety.

And yet, this now “oldest ever” bull market just… keeps… moving… HIGHER!

Consider the fact that the S&P 500 is up 8.8% year-to-date, while the Volatility Index (aka “the Fear Gauge”) is up 21.2%.

See what I mean about higher stock prices and higher anxiety levels?!

It’d be natural to think that this curious combination – of higher prices and higher anticipated volatility – is a warning sign.

You’d think, perhaps, that it’s indicative of an over-priced market that’s just one step away from panic.

“Dicey,” at best.

But you may be surprised to see what I found when I dug into the data…

You’ve probably been told that “stock prices and volatility are inversely related.”

That’s a fancy way of saying, “when one goes up, the other goes down.”

But that relationship isn’t nearly so cut and dry.

In fact, over the last 25 years, there have been eight (8) instances in which the S&P 500 and the VIX were both up after the first three quarters of the year.

Those instances occurred in: 1996, 1997, 1998, 2006, 2007, 2010, 2013, and 2014 (and now 2018).

You can see three of those years came during the late-90s dot.com bubble… two of them during the final stage of the next bull market rally… and three of them during this current bull run.

Essentially, they’re a fairly common occurrence during bull markets. And they’re not typically indicative of immediate danger.

Seven out of eight of those instances (87.5%) resolved with strongly positive S&P returns three (and twelve) months later.

Buying the S&P 500 on October 1, after both the S&P 500 and the VIX are up through Q3, has resulted in an average profit of 7.6% over three months and 11.5% over 12 months.

That’s the best Q4 return you can earn, given the four possible combinations of S&P 500 and VIX returns.

Take a look…

  • Positive S&P, Positive VIX: earns you 7.6% in three months
  • Positive S&P, Negative VIX: earns you 6.4% in three months
  • Negative S&P, Positive VIX: earns you 2.8% in three months
  • Negative S&P, Negative VIX: earns you negative 3.3% in three months

If you notice, the first-three-quarters return of the S&P 500 is more predictive than the return of the VIX over the same time.

You can see how the two best results (+7.6% and +6.4%) follow positive S&P 500returns in the first three quarters. And the two worst results follow negative S&P returns.

On the other hand, the VIX appears to work as a contrarian indicator in these instances.

If the S&P 500 is up, stronger returns follow a period of positive VIX returns (versus negative VIX returns). And that’s also the case even when the S&P 500 is down during the first three quarters.

You may have heard the saying, “stocks climb a wall of worry.”

I think that’s the best way to sum up what’s happening in these both-up scenarios – that is, when stock prices and volatility are both up.

It’s twisted, but stock prices tend to do best while most folks are too fearful to invest.

And if this year continues to follow that script, we could see major market indices up another 5% or more by year-end.

Adam O'Dell

As Chief Investment Strategist for Dent Research, Adam O’Dell has one purpose in mind: to find and bring to subscribers investment opportunities that return the maximum profit with minimum risk. He achieves this with his perfect blend of technical and fundamental analysis.MORE FROM AUTHOR