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Better Signals for Risk Bearing, Conviction Than S&P 500, VIX

Better Signals for Risk Bearing, Conviction Than S&P 500, VIX

John Kicklighter,

Talking Points:

VIX is a favorite risk gauge for many, but its predictive ability does not often measure up to its reputation

• Changes in market benchmarks - like the S&P 500 - can signal risk trends but not necessarily conviction

• An earlier measure of a shift in conviction is changing correlations between risk-sensitive assets

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While the rise of competitive global trade policy currently commands the greatest influence over the financial system, risk trends can quickly take command with the proper motivation. Nevertheless, it is critical to keep close tabs on an elemental theme that could suddenly change the course of global capital flows. Yet the measures we default to as preferred signals for the shift in sentiment may not offer the most timely and/or accurate indication of the market's 'season'. The most recognizable US equity indexes and VIX volatility index represent some of the most recognizable and frequently referenced metrics for sentiment. Yet, correlation across a variety of risk-sensitive assets may represent the more comprehensive assessment.

The VIX has been billed as the perfect 'risk' indicator. Derived from the insurance costs behind one of the most recognizable investment benchmarks in the markets (S&P 500 options), it would seem adept as taking the temperature of the investing rank. However theory doesn't always live up to reality. A look back at the otherwise high correlation between the volatility index and the S&P 500 shows that though the measure may be derived from implied (expected) measures, it has frequently played the role of a reactionary measure rather than a leading indicator. Conviction - or commitment to the significant turns in trend - can be the frequent shortfall from key benchmarks like the US stock index. Just in the past two years, we have seen sudden drops from the S&P 500, Dow and other preferred measures in response to Brexit and the lead up to the US election. Yet, neither event signaled a lasting turn of tide.

The flows from these measures comes through the filter of speculative appetite itself. Though options are in essence a hedge on underlying holdings, investors frequently forgo the cost of protection when it is most necessary. US stock markets are currently an ideal example of how complacency can permanently warp reasonable investment decision making in the pursuit of higher return. The better measure in the place of these two standard bearers is arguably the correlation across a variety of assets that hitch their performance to sentiment. When a single measure of risk takes a dive, it can highlight a particular fundamental influence to that asset rather than a shift in underlying sentiment overall. When otherwise disparate market charges rise or fall in tandem with true conviction, it can offer a more comprehensive assessment of investment motivation itself rather than particular markets falling in or out of favor. We take a look at how correlations between different risk assets can offer a better signal for speculative appetite than well-known preferences in today's Strategy Video.

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DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.