Predicting Stock Returns When the VIX Is High
- By Sam van de Schootbrugge
- 6 min read
Summary
- A Journal of Financial Economics paper explains why market sentiment measures are most valuable to investors when uncertainty is peaking.
- The authors find an increase in investor sentiment predicts lower market returns over the subsequent three days. This predictive power is two to four times greater when the VIX is one standard deviation higher than its mean, as it is today.
- The paper shows how we can use the VIX and popular sentiment measures, such as the University of Michigan Consumer Sentiment Index, to predict short-term returns.
Introduction
In uncertain times, asset prices can fluctuate wildly as investors lean more on their ‘animal spirits’ than market fundamentals. Uninformed traders, of which there are more in times of economic stress, increasingly look towards sentiment measures to validate their trading decisions. This opens the door to greater subjectivity in valuations, which increases the chance assets will be mispriced.
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