Abnormal Stock Market Returns Around Peaks in VIX: The Evidence of Investor Overreaction?

Abstract

Even though the VIX index was intended to be a measure of future volatility of the stock market, researchers argue that in reality VIX measures the investor sentiment. Anecdotal evidence suggests that peaks in VIX coincide with stock market bottoms followed by rallies, yet so far there have been no scientific evidence confirming this casual observation. In this paper we perform an event study of abnormal stock market returns around peaks in VIX and discuss our findings within the framework of behavioral finance theory. First of all, we detect peaks in VIX using formal turning-point identification procedures and provide detailed descriptive statistics of periods of rising and falling VIX. The results of our event study reveal strong evidence of the presence of abnormal stock market returns around peaks in VIX. We argue that the pattern of abnormal returns can be attributed to investor overreaction to bad news with subsequent correction. To validate our conjecture, we test whether the abnormal returns around peaks in VIX satisfy the two properties of overreaction. We find that the results of these empirical tests are consistent with the overreaction hypothesis. To further confirm the idea that the VIX index reflects the investor sentiment, we test the predictions of behavioral finance theory which postulates that investor sentiment affects various types of stocks to different degrees. In agreement with the theoretical predictions, we find evidence that over the event window around a peak in VIX the prices of large and value stocks undergo a relatively small downward correction, while the prices of more speculative small and growth stocks are corrected down to a higher degree. Our additional tests suggest that these cross-sectional differences cannot be explained by a set of standard risk factors.