Caution: Rising Fear Gauge Should Give Investors Pause

With Wall Street freaking out over the potential slowdown of Fed stimulus, the VIX volatility index recently broke through the closely-watched 20 threshold for the first time since the end of 2012.

While some traders may be cheering the uptick in market turbulence after a long period of tranquility, the rising volatility may actually increase the chances the S&P 500 suffers its first 10% correction in almost two years.

That’s because recent research from Citigroup (NYSE:C) reveals VIX levels of 20-25 are associated with lower probabilities of market gains.

Since 1990, when the volatility index trades between 20 and 25, the S&P 500 sports a 12-month gain just 60.4% of the time, compared with 86.1% for VIX levels of 15-20 and 87.9% when the VIX is at just 10-15.

“Investors may be encouraged by a VIX reading above 20 but they shouldn't be,” Tobias Levkovich, Citigroup’s (NYSE:C) chief U.S. equity strategist, wrote in a note to clients late last week. “The so-called ‘fear gauge’ is wildly misunderstood and misinterpreted by many equity observers.”

In fact, the 20-25 range has the lowest likelihood of 12-month gains of any of the five-point brackets broken out by Citi.

Likewise, the S&P 500’s average six-month gain is just 0.3% when the VIX is trading between 20 and 25, compared with 5.3% when the VIX is 10-15 and 2.9% when it’s 15-20.

Elevated Volatility Prompts Buying Opportunity?

Interestingly, equities tend to perform best when the fear gauge rises uncomfortably high.

According to Citi, the S&P 500 has generated an average 12-month return of a whopping 32.6% when the VIX is at 45-50.

Volatility hasn’t been at those levels since October 2011 when the sovereign debt crisis in Europe flared up, causing the collapse of brokerage firm MF Global. During the 12 months following that spike in the VIX, the S&P 500 soared roughly 26% to 1461 as the eurozone calmed down and the U.S. recovery was steadied.

“It makes absolute sense. It’s the classic buy when there’s blood in the streets type of indicator,” said Nicholas Colas, chief market strategist at ConvergEx.

While the VIX jumped as high as 21.91 on Monday, it has since retreated to as low as 18.10 on Tuesday. By comparison, the gauge's long-term historical average is around 20.

The recent jump in the VIX leaves the volatility index at its highest level since hitting 22.72 during the final week of 2012 as Washington struggled to come to a fiscal-cliff compromise. After a deal was brokered, the fear gauge plummeted to just above 12 in late January and then 11 in March.

QE Jitters Spark Turbulence

But uncertainty has crept back into the markets in recent weeks as the Federal Reserve has signaled an increased willingness to dial back on its monthly bond purchases of $85 billion due to the improved economic outlook.

Since Fed chief Ben Bernanke first suggested the central bank could slow its monetary stimulus on May 22, the Dow Industrials have experienced a whopping 11 sessions of 200-point swings. In eight of those days, the index landed in the red. By comparison, the Dow saw just four such high-volatility days for all of 2013 prior to May 22.

Over that timeframe, the S&P 500 has retreated from an all-time intraday high of 1687.18 to as low as 1560.33 on Monday, a drop of 7.5%. The index is only another steep selloff away from its first correction, technically a 10% decline from a prior high, since the 19% tumble between April 2011 and October 2011.

Colas said in addition to the VIX, he closely tracks the volatility in the Treasury market, which has seen heavy turbulence amid the lingering quantitative easing question marks.

“What equity people need to understand is that the volatility in equities is not equities based. It’s fixed-income based,” he said.

That means before making a determination on which direction volatility is going for stocks, investors must make a bet on bond volatility.

The equity volatility needle has also been bumped up by other developments, including uncertainty over the Bank of Japan’s stimulus efforts, a worsening credit crunch in China’s slowing economy and new concerns about Europe.