The S&P 500 Index (SPX) has stalled recently, yet it’s still trading close to its all-time high. At the same time, option traders seem to be getting nervous. The Cboe Volatility Index (VIX), which measures the 30-day implied volatility (IV) on the SPX based on option prices and is often referred to as the market’s “fear gauge,” has risen to around 20. That seems like an elevated level given how close the SPX is to the all-time high. This week, I’ll look at the historical data to see what has tended to happen when the VIX is elevated while the SPX sits near an all-time high.

An Elevated Market Next to an Elevated VIX

With the stock market near highs, a bullish case can be made given the elevated level of the VIX. A high VIX suggests significant hedging activity, meaning investors are skeptical of the lofty stock prices rather than euphoric. When traders are hedged, pullbacks sting less, giving them less reason to sell into the weakness. In addition, investors are likely not fully invested, leaving potential buying power on the sidelines.

Now let’s quantify this setup. On Tuesday, the SPX closed within 2% of its all-time high, while the VIX closed above 20. The two tables below show SPX returns after the index closed within 2% of a record high. The first table only included instances when the VIX closed above 20. The second table shows the returns for when the VIX was below 20.

Based on this data, our theory looks correct. When the market was within 2% of its high and the VIX was above 20, the index gained an average of 3.71% over the next three months. When the VIX was below 20, the average three-month return was just 1.47%. Forward returns were stronger at each examined timeframe when the VIX was above 20.

Interestingly, the percentage of positive returns was similar in both cases. The outperformance stemmed from larger upside moves of the SPX when the VIX was elevated (as measured by the average positive returns). This suggests the main driver of the bullish market returns when the VIX was high was the sideline money available to push the market higher.

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Here’s one more way I looked at it. Tuesday’s setup with the index near its highs and the VIX above 20, was the first instance since October of last year. Although, instances such as when it’s the first reading over the past month, 19 signals appear. The first table shows returns after those signals, while the second table shows typical SPX returns since 1996 (the year of the first signal).

The short-term results show outperformance with the SPX averaging a return of 0.93% over the next month with 74% of the returns positive compared to the typical average return of 0.79% and 64% positive. However, that changes for the longer-term results. The returns were bearish after these signals from three months to a year compared to typical SPX returns.

Story continues

This tells me the path of the VIX could matter. If it remains elevated, it indicates healthy skepticism to support the market. But on the other hand, if the VIX quickly retreats to lower levels, it reduces the probability of a sustained rally going forward.

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