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Sunday, August 26, 2012

Don't Be Puzzled By A Low VIX.

On August 17, 2012, the closing value of VIX was 13.45, a level not seen since June 19, 2007 when the closing value of VIX was 12.85.  The recent lows in VIX has many naysayers talking.  Never mind the fact that SPY prices have hit new highs since May 2008.  "Such a low VIX level shows investor complacency and has been a reliable signal of market tops", claims the talking heads that are equally in disbelief that the equity market keeps going up and up.

I must admit, with all the problems unresolved in Europe, concerns over Chinese economic slowdown, and possible falling off of the fiscal cliff in the U.S., it is easy to sympathize with their arguments that this equity market has been manipulated upwards by central banks and that it is set for a free fall.

I would like to take a different perspective.  Recent earnings announcement from Cisco got me thinking.
1) that the global economy is not as weak as once feared
2) U.S. multinational companies are still enjoying the benefits of global markets reach and growth
3) S&P500 Index is more and more comprised of these multinational, global companies.

So I took IMF's global GDP growth figures and projections and plotted the long-term, monthly VIX inverse levels on top of it.  What the graph below shows is that inverse of VIX follows the annual global GDP growth rates very closely.  Perhaps this is the reason why the equity markets have continued their bull-run and VIX levels have declined to their lowest levels in years.  If the GDP projections end up close to reality, VIX could easily move within 10-20 range as it did from 2003-2006.

Perhaps, VIX falling to 13.45 level recently should be taken as a signal of an equilibrium shift in VIX levels happening before our eyes.  As you can see from the graph below, VIX has in the past moved from low volatility equilibrium to high volatility equilibrium and back and forth.  Should IMF projections for 2013 GDP growth be right in its direction, there should not be a reason to discredit the possibility that VIX has shifted to lower equilibrium levels.

If this is the case, then I must consider utilizing the Blue/Cyan median VIX levels in my models from hereon to calculate expected VIX levels, rather than using the long-term median VIX levels in Black/Grey.  I have not accepted this 100%, but I am considering making this adjustment.

One thing for certain is that VIX futures prices and VIX futures term-structure are still showing a steep contango.  One of the best bets to make throughout the past 11 months was to short front-month VIX futures as the steep premium of VIX futures prices moved to zero at expiration settlement.  I believe that shorting VIX futures would still be a good bet going forward, especially in consideration of the possibility that an equilibrium shift to low levels is now taking place.  I will continuously be looking for opportunities to short VIX futures delta by shorting VIX futures, using VIX and VXX options, shorting VXX, going long XIV, shorting VXZ, or going long ZIV as long as the contango remains steep.

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