The VIX is broken. This is what I think comes next.

Anyone who has been following the VIX knows that it's not acting normal right now.

Since markets bottomed in March 2009, the S&P 500 and the VIX have consistently maintained an inverse correlation, with the volatility index typically drifting steadily lower as equities powered to new highs (think 2017, when the VIX fell into single digits amid steady stock market gains) while bouts of volatility and short-lived selloffs in the stock market saw the VIX spike higher. Digging into this relationship deeper, when stocks made new meaningful lows below exceptional support levels, the VIX would almost always rise to new highs beyond those that corresponded with the previous lows in stocks. 

For example, as the S&P 500 (SPX) dropped below the lows from late 2018 (2,346) during the Q1 ’20 Covid-19 crash, which carried the index down to 2,191, the VIX blasted through the late-2018 high of 36.20 and peaked at a staggering 85.47. The uncertainty associated with the first pandemic in 100 years certainly amplified the move higher in the VIX in that example, but it does illustrate the point of the traditional inverse correlation between stocks and the VIX very well.

Now, the actual formula and process used to calculate the VIX is very complex and involves some high-level math, but in the simplest terms, the index measures price activity, mainly demand, in the options market. That is why in normal market conditions, the VIX rises amid increasing demand for puts as the broader stock market declines, and this is also the reason it is often referred to as the market's “fear gauge.”

But at both of the most recent major market peaks that occurred in 2000 and then again in 2007/2008, that historically consistent inverse correlation between the stock market and the VIX broke down as new meaningful lows in the S&P 500 were not met with new highs in the VIX. And it has happened again this year. 

The logical question to ask here is: why would this happen?

As stocks make new meaningful lows, as they first did in February, then again in May and June of this year, sophisticated investors were actually liquidating long-term, long equity positions as opposed to holding those positions and just adding hedges to manage risk and downside exposure.

So, what we are seeing in the VIX and the S&P 500 right now is the same thing we saw in both 2000/2001 and 2007/2008 in the early stages of those respective bear markets. And the bad news is that this dynamic only persists during the “distribution phase” of market cycles when sophisticated investors are liquidating to retail investors attempting to “buy one more dip.” Once the VIX finally breaks the downtrend of “lower highs” and begins to move meaningfully higher, the real breakdown and capitulation in stocks begin.

Looking at the dot-com bubble, the downtrend in the VIX was broken in September 2001, and the S&P 500 proceeded to decline another 30% or so, as the VIX ripped higher, finally bottoming in late 2002. During the financial crisis, the VIX downtrend was not broken until September 2008, and the S&P 500 fell another 47% to the March 2009 lows (of course, the VIX ripped higher as well).