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On Monday, we offered an analysis showing that despite the relatively low levels of the Cboe Volatility Index (VIX), it was in fact somewhat elevated when we consider the historically low levels of certain correlation measures. After digging a bit deeper into those initial assertions, I have found some more indications that there may be more risk aversion being priced into the market than it may appear.
First, let’s update one of the graphs we used in the prior article. We plotted VIX against two of the Cboe’s correlation indices, COR1M and COR3M. According to the Cboe, these measure the average expected correlation between the top 50 stocks in the SPX index, on a 1-month and 3-month basis, respectively. They are actually a bit lower than where they stood on Monday:
Since January 2006: Cboe COR1M (blue/white monthly candles, right scale), COR3M (red line, right scale), VIX (green line, left scale)
Source: Bloomberg
More recently, the exchange created a similar measure called the Cboe S&P 500 Dispersion Index (DSPX). According to the exchange’s definition:
[DSPX] measures the expected dispersion in the S&P 500® over the next 30 calendar days, as calculated from the prices of S&P 500 index options and the prices of single stock options of selected S&P 500 constituents, using a modified version of the VIX® methodology.
In contrast to “realized dispersion” — a measure of independent movement observed in the components of a diversified portfolio — the Dispersion Index is a forward-looking implied measure. The index may provide an indication of the market’s perception of the near-term opportunity set for diversification or, equivalently, as an indication of the market’s perception of the near-term intensity of idiosyncratic risk in the S&P 500’s constituents.
Dispersion is not exactly the inverse of correlation, but it can be considered in that manner. That index hasn’t been back calculated for as long ago as the COR indices, nor is it at an all time high, but it is close, as shown in the graph below:
Since January 2006: Cboe COR1M (white, right scale), VIX (green, left scale), DSPX (yellow, left scale)
Source: Bloomberg
In this case, it is interesting to note that while DSPX typically moved in generally the same direction as VIX, lately they have diverged quite substantially. Quite frankly, the latter is the behavior I would have expected. An index comprised of companies with highly dispersed results would have somewhat depressed volatility. And this is what we have seen recently. The 20-day historical volatility of the S&P 500 (SPX) is at a post-covid low:
4-Years, SPX 20-Day Historical Volatility (red), Implied Volatility (blue), Index Level (yellow)
The takeaway here is less that both historical and implied volatilities are at lows – we have outlined the reasons why historical volatility would be depressed, and it stands to reason that implied volatilities would follow – but instead that there is a relatively wide gap between implied and historical volatilities. That tells us that there is relatively sufficient demand for SPX options to keep the implied volatility at a relatively substantial premium. The spread is not historically wide during this timeframe. The maximum occurred in November 2021. It’s probably not a coincidence that the NASDAQ 100 (NDX) hit a two-year peak at that time and SPX peaked about six weeks later. Or is it?
Related: VIX: It’s Not Just Complacency