Why an underperforming market could be ahead

The CBOE Volatility Index (VIX) is around the 20 range. Although this level is not extremely high, it is elevated compared to the historical 20-day volatility (HV) of the S&P 500 ETF (SPY). Additionally, the VIX recently closed above 20 while the SPY's 20-day HV was below 10 – an unusual occurrence.

For those unfamiliar with the VIX, it is calculated using S&P 500 Index (SPX) options and measures the expected volatility of the market for the SPX over the next 30 calendar days, which is approximately 20 trading days.

The VIX is typically slightly above the 20-day HV, but moves in parallel with it. Recently it has been trending in the opposite direction of HV as you can see in the chart below. This week I examine how stocks tend to perform based on the VIX compared to the SPY's HV.

The SPY's 20-day HV recently fell below 10% for the first time since July. The first table below shows how the SPY performed when its 20-day AGM was below 10%, using data since 2000.

The second table shows how it performed at other times. Under these circumstances, the SPY tended to underperform typical market returns in the first three months, albeit only slightly. The percentage of positive returns corresponds to typical returns. The underperformance is due to limited upside potential. The standard deviation of returns is significantly lower, as expected, while longer-term returns (six months) have been bullish.

With the SPY's 20-day HV currently in the single digits, the VIX is forecasting significantly higher volatility over the next 30 days. The inequality could be related to next week's election. In the tables below, I analyze SPY returns when HV is below 10%, categorized by VIX premium over HV. Currently, VIX is around 20, while SPY's 200-day HV is below 10%, resulting in a VIX premium of over 100%.

The tables show that the SPY tends to underperform in these situations. In these low HV and relatively high VIX situations, the SPY returned an average of 0.19% over the next month. The second table shows when HV is below 10% but the VIX is more in line with HV. In this case, the ETF returns an average of 0.52% over the next month. Based on the data listed above and below, it would not be surprising to see the market perform slowly and underperform in the future.

With the election coming up, I thought it would be interesting to see what the SPY 20-day AGM and VIX typically look like before elections. I marked the lines that look most similar this year in bold.

The story continues

In 2012 and 2016 we had a VIX value of just under 20, with the 20-day HV significantly lower. The SPY got off to a slow start after the 2012 election, falling almost 4% over the next few weeks. However, returns increased significantly in both years thereafter: the SPY rose about 7% after three months and 12% and 14%, respectively, over the next six months. Most investors would be happy with that.