NORMAL CORRECTION OR SOMETHING MUCH MORE PAINFUL?

The S&P 500 experienced a peak-to-trough drawdown of 7.83% between the July closing high and last week’s closing low. The VIX (VXZ) can be used in a weight-of-the-evidence approach to examine the correction or bear market question. The analysis will provide insight into the intermediate-term risk-reward profile of the SPDR S&P 500 ETF (SPY).

According to the CBOE, the VIX is designed to produce a measure of constant, 30-day expected volatility of the U.S. stock market. In general, VIX levels between 0 and 15 tend to occur during periods of optimism and low volatility. When the VIX is between 15 and 25, concerns are elevated, but not in an alarming manner. VIX readings between 25 and 30 are in the “pay closer attention” range. VIX readings over 30 are usually associated with high volatility that is expected to continue.

2023 VS. LARGE S&P 500 DRAWDOWNS

All things being equal, if market participants were concerned about a significantly larger S&P 500 drawdown and expected recent volatility to continue or even expand, we would expect to see an elevated VIX. Since the current 2023 maximum drawdown is 7.83%, it is helpful to ask and answer the following question:

In cases that featured bear-market-like drawdowns, what was the VIX level after the initial 7.83% decline in the S&P 500?

To answer the question above, we examined the ten cases below that featured an average S&P 500 drawdown of 27.38% and a median drawdown of 19.81%. After the initial 7.83% decline, which is similar to what just occurred in October 2023, the median VIX level was 31.08; the average VIX level was 31.65. Both of those levels are significantly higher than the VIX reading of 19.78 on October 3, 2023 when the S&P 500 registered a 7.83% drawdown, meaning present-day volatility expectations are significantly lower than the study periods listed in the table below.

Moral of the Story

No indicator or datapoint can predict the future, including the VIX. The VIX, like numerous other indicators and datapoints, can be used in a weight-of-the-evidence fashion to assess SPY’s risk-reward profile. Thus far, the VIX level on October 3, 2023, aligns more closely with a normal correction relative to a bear-market-like drawdown in the neighborhood of 20-27%. Concerns would increase if the VIX pops into the 30s in the coming days. Thus far, the pullback in stocks has not inflicted significant damage to the case of a demographically driven secular bull market.

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