SKEW Index Hints Towards Strong Market Performance in the Months Ahead

“The CBOE SKEW Index ("SKEW") is an index derived from the price of S&P 500 tail risk. Similar to VIX®, the price of S&P 500 tail risk is calculated from the prices of S&P 500 out-of-the-money options. SKEW typically ranges from 100 to 150. A SKEW value of 100 means that the perceived distribution of S&P 500 log-returns is normal, and the probability of outlier returns is therefore negligible. As SKEW rises above 100, the left tail of the S&P 500 distribution acquires more weight, and the probabilities of outlier returns become more significant. One can estimate these probabilities from the value of SKEW. Since an increase in perceived tail risk increases the relative demand for low strike puts, increases in SKEW also correspond to an overall steepening of the curve of implied volatilities, familiar to option traders as the "skew".” https://www.cboe.com/products/vix-index-volatility/volatility-indicators/skew

The CBOE SKEW Index has been rising over the past several months and closed Friday at 131.39. This increase in perceived tail risk has fallen very dramatically from the peaks of several weeks/months ago. We track the MACD (20,50,10) on the SKEW and overlay the Bollinger Band with a (200,1) setting. What we find is that the market (S&P 500) outperforms significantly in the several weeks and months following a drop below one and two standard deviations from the mean.

We examined the SKEW Index back to 1990 and found that when the SKEW MACD (20,50,10) drops below one standard deviation from the mean (as it is today) the S&P 500 has shown better than average performance.

Let’s start with the expected one-month SPX performance when the model sits below one standard deviation. Out of 6619 observations this event has occurred 1197 times or only 18% of the time since 1990. When the model has dropped below one standard deviation the average one-month return for the S&P 500 has been 1.9% compared to only 0.5% in the occurrences when the model was above one standard deviation. In the occurrences when the model was below one standard deviation the market went on to be higher 70.5% of the time compared to just 61.0% of the time when the model was above one standard deviation.

If we come across the very rare occurrence when the model drops below two standard deviation (this only happened 175 times out of 6619 observations or 2.6% of the time) the forward one-month returns were even more pronounced. At minus two standard deviations, the S&P 500 was up on average 2.4% in the next month and was up 76.0% of the time.

Compare this to when the model is over one standard deviation. The average one-month return is just 0.4% on average and up only 61.4% of the time. When the model is above two standard deviations (this only happened 4% of the time since 1990) the average one-month return is 0.0% and is up 58.8% of the time.

The chart below shows the average one-month return of the SPX at different model intervals.

The two month return for the SPX are equally impactful when the model reaches its outlier levels.

At minus one standard deviation the average two-month return is 2.5% and up 70.8% of the time as opposed to just 1.2% and 64.3%, respectively when the model is above minus one standard deviation.

At minus two standard deviations the SPX averages 3.3% over two months and is up 77.7% of the time.

We have conducted this study using three and six months returns as well and the results are still impressive, although it seems the greatest returns come in within the first two months. We have attached the following charts to show the three and six months returns as well as a graphic for review.

Bottom Line: Using the SKEW Index is one of many tools used to determine our tactical strategy and portfolio hedging decisions. Based on the historical data used here, it would indicate that the market will continue its upward trend as it strives for ever new highs.

Joseph S. Kalinowski, CFA

Email: joe@squaredconcept.net
Twitter: @jskalinowski
Facebook: https://www.facebook.com/JoeKalinowskiCFA/
Blog: http://squaredconcept.blogspot.com/
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