The fear index is something that you might have heard before; it’s a phrase widely used between stock market investors and traders as a general term to describe volatility in stocks. ‘Fear Index’, also sometimes referred to as the ‘fear gauge’, refers to the CBOE ‘Volatility Index’ – or the VIX.
The VIX is used to measure the expected volatility on the stock market. It makes use of S&P 500 index options to calculate, to an extent, any predicted variance (or volatility) for the following 30 days.
How Stock Prices Correlate with Market Volatility
It’s hard to say for certain whether the Fear Index is an accurate way to measure or predict future realized volatility, as there are always outside contributions that may affect the market in entirely unexpected ways. The VIX does, however, act as a great measure of ‘Investor Sentiment’.
What is Investor Sentiment?
Investor sentiment is defined as the overall attitude of investors toward a specific product market; if the VIX shows volatility in one area, it will demonstrate to us that investors expect the market to move heavily in another direction over the upcoming 30-day period.
As the investor sentiment changes (either as a cause or a reaction to the VIX), so will the stock prices. Market volatility is simply a reflection of how a certain stock is expected to change: if one market is especially volatile, it’s a high probability that it represents a declining market, and subsequently lower stock prices.
So, is the VIX really deserving of its title as a fear gauge? Here, we’ll be using the time series database provided by TimeNet to evaluate and analyze this claim.
Using TimeNet to Explore the Data
TimeNet allows us to explore and analyze a virtually infinite time series, or “a series of values of a quantity obtained at successive times, often with equal intervals between them.” For example, we can compute correlations between the number of google searches for an arbitrary term over a set period of time, to discern how people’s search habits have gradually changed.
This, in turn, will allow us to assess the degree to which the VIX is an actual measure of fear, or if it bears no impact on investors whatsoever. It’s safe to assume that in times of fear regarding the stock market, there will be a significantly higher interest in negative financial terms such as ‘recession,’ or even ‘depression.
These search terms will then be shown in Google’s search stats, allowing us to review them and actually determine whether there is any level of fear.
The VIX index and the popularity of the search term ‘Recession’
As we can see, the popularity of the search term recession positively correlates with the VIX; the direct co-movement of these two series signifies that the name ‘fear index’ is certainly appropriate.
The primary reason that we refer to the VIX as the fear index is that when it rises, the market usually falls; this creates a sense of fear amongst many investors as they panic about potential monetary losses.
The S&P 500 index is a good proxy for the overall US stock market, as it’s comprised mainly of the stocks of 500 larger or dominant companies. It represents a huge share of the overall economy, making it a great database when it comes to measuring the general volatility of the stock market.
The values of the S&P 500 index and the VIX usually move in opposing directions: as the stock value of one company increases, the level of volatility usually decreases as the stock becomes more stable. This is proven within the time period that we’ve examined, too.
The figure below clearly shows that when the VIX rises, the market index tends to fall and vice versa. This high negative correlation is unmistakable:
The VIX index (blue) and the S&P index (orange)
The relationship between the fear and S&P indices seem to be very strong and very clear – but does this correlation hold true for all stocks separately, or only as individuals and aggregates? In order to truly understand this, we need to also examine how the fear index compares to individual stocks on the market.
Whilst the S&P 500 Index has a recognizably strong negative correlation with the CBOE Volatility Index, these results can (and do) massively vary between individual stocks. Generally, most stocks do correspond to the VIX, but during our analysis, we did identify a few exceptions.
For example, Starbucks, National Instruments, McDonalds, Verizon and Coca-Cola have moderate – or even positive – correlations with the VIX.
When looking at two or more different time series, if they both generally move in the same direction, it is referred to as a positive correlation. So, when the VIX and the S&P 500 Index both rise, they move in a positive correlation.
Positive correlation is relatively rare in terms of the fear index; negative correlation is certainly more commonplace. Here are a few stocks that do correlate negatively with the VIX, further confirming this point: SAP, Apache, ExxonMobil, FedEx, Google…
Many of the companies that do harbor positive correlations cater to somewhat lower-level or necessary human needs, such as food (such as McDonalds) and drinks (such as Coca-Cola and Starbucks) – this could potentially suggest that on a consumer level, as well as on an investor level, that companies like the ones that exhibit these correlations are too much of a necessary investment to warrant any concern.
It seems like investors aren’t as likely to worry about volatility in these markets.
Several of the (strongly) negatively correlated stocks belong to large technology companies, such as computer or mobile firms, software developers and those that belong to the energy industry.
These companies do seem to suffer more when the volatility index suddenly jumps or changes, displaying a direct negative correlation: If the fear index shows an increase, the stock price will likely decrease.
In many cases, a change in the fear index does forecast a potentially sinister landscape for many companies – however, this doesn’t always hold true. Different companies and industries are affected in different ways, depending on a few measurable factors.
What can the Volatility Index say about your company?
If you’re interested in learning more about your company, or how the fear index might impact your stock prices, it’s surprisingly easy to do so – even if your company is not listed on the stock exchange!
All you need to do is upload your time series (prices, dates etc.) to TimeNet cloud – it will map out the correlations, which you can then analyse as we’ve done throughout this article.
To summarize, we can directly answer the question posed at the beginning of this article: “is the VIX really deserving of its title as a fear gauge?”
In short – yes, it’s entirely appropriate to refer to the VIX as the fear gauge, as it does a great job of predicting, for the most part, fear or concern between many investors.
The Volatility Index should not, however, be used as a complete guide: whilst it can provide some extremely helpful insights, there are some correlations that do go against the VIX and can actually positively correlate with the S&P 500 Stock Market.
The Volatility Index largely correlates negatively with the stock market, along with general concern towards recessions (as proven via search results), though it does not necessarily show the same correlatives for every individual stock on the market.
If you’re interested in carrying out your own research on this topic, you can use the TimeNet cloud to make similar discoveries.
It is important to note that the relationships that we have found may be entirely coincidental, and they may not exist at all times.