Volatility is back. The market is beginning to falter under the barrage of geopolitical turmoil, depressed commodity prices, muted earnings, and now a drop in consumer confidence.
The gauge that measures consumer sentiment fell from 93.4 to 86 from last month to September – an 8% drop that brings a sudden end to a 4-month increase in expectations. A look at the CBOE VIX Index, colloquially known as the “fear gauge,” reveals a sharp rise in the past two weeks of trading. Since September 19th, the VIX has climbed nearly 35% from 12.11 to 16.31 as of September 30th.
Many investors look at the sudden increase in volatility as a warning sign, but it could be seen as a trading opportunity for those willing to take a little more risk.
Volatility In Stocks
Volatility is one of the fundamental forces of the stock market universe. Much like gravity is responsible for maintaining the orbits of the planets, volatility keeps the market functioning and allows trading to occur.
The standard definition of volatility is that it is a measurement of the dispersion of returns in a given security or market. In other words, if the dispersion is more erratic, then the security would be more volatile and therefore garner a higher rate of return to compensate an investor for the perceived risk in owning it.
Volatility can be thought of as a roller coaster. You may be more of a thrill-seeker who chooses to ride the tallest, fastest roller coaster around because you enjoy the exhilaration associated with it and you feel comfortable with taking a risk and feeling fear.
Other riders tend to be more cautious and choose a mellower ride that doesn’t offer as many loops and drops, but maintains a steady speed that they would be comfortable with. You don’t like the feeling of fear and danger and would rather have more security instead.
These differences in high-volatility and low-volatility investments are expressed in their returns. Stocks with a lot of volatility can rise and drop in value at a faster rate than the overall market. During a bull market, these stocks outperform, but during a bear market, they can sustain heavy losses.
Stocks with low volatility are just the opposite. During a bull market they tend to underperform the averages, but outperform during bear markets. Investors in these stocks can identify with the tortoise in the well-known story of the tortoise and the hare. Slow and steady.
When an increase in volatility happens on a macro scale, it can cause unexpected results. Higher volatility stocks may become too risky compared to their expected rate of return, while stocks with less volatility can suddenly look far too cheap for the same reasons.
Volatility Won’t Change The Fundamentals
We know that volatility increases risk and causes greater variations in returns. However, we haven’t stated that volatility drastically affects strong companies in any real way. Smart money understands that volatility doesn’t change a good stock’s fundamentals.
Higher volatility can actually help weed out poor companies. The financial gyrations can close the doors of marginal firms while freeing up strong companies to get the financing they need to grow. Stocks with negative returns or low margins can find themselves facing difficult decisions during these times, but it can help boost the value of stocks that are fundamentally strong, albeit less popular.
Volatility is actually a big difference between growth stocks and value stocks. Growth stocks have higher amounts of volatility while value stocks have less. Numerous studies have been done to test which type is more profitable over the long run, but none have a definitive conclusion. It’s safe to say that they perform equally over long time periods, but can fluctuate in the short term.
When the market as a whole experiences higher volatility, it can create price disparities that investors can take advantage of. A fundamentally strong growth stock may dip in value as increased uncertainty steers investors away from companies with high price-to-earnings ratios while value stocks with a lower price-to-earnings multiple get a sudden lift.
Another way to tell how a stock will react to volatility is by looking at its beta. Beta is a figure that tells you how much a stock will respond to price and volatility swings in the market. A beta of 1 indicates a stock that will move in lock-step with the market average. If the S&P 500 rises 1%, you should expect the stock, all other things being equal, to rise 1% as well. A higher beta means the stock will move more than the market average. If a stock has a beta of 1.5 and the S&P 500 climbs 1%, the stock will rise 1.5% meaning that it’s 50% more volatile than the market. A lower beta will indicate just the opposite.
Some stocks may even have a negative beta which means that the stock will move in an opposite direction that the market does. A beta of -0.5 means that it will lose 0.5% for every 1% gain in the overall market. Of course this also means that these stocks will post gains when the market is in decline.
Matters Of Performance
Greater volatility can mean greater opportunities for investors in the stock market. The reasons for the increase may be due to economic uncertainty or the blame could be laid at the feet of institutional traders. Sometimes it can be the effects of both. For these reasons, performing due diligence on a stock you want to invest in becomes more important than ever.
An investment should always be made for fundamental reasons. Companies with strong margins, reasonable price-to-earnings ratios, growth prospects, and a wide economic moat – a competitive advantage over others in their industry – should be the basis of your investment.
Fluctuations in the marketplace can be used to your advantage – it can enable you to buy a stock for a discounted price. It can also help call a bottom.
Generally, a higher reading of the VIX coincides with lower stock prices. As the VIX climbs, the market declines. It can indicate a good time to buy stocks as values increase and indicates to investors to sell when volatility reaches a low point.
This chart shows how the VIX and the S&P 500 are inversely correlated. The correlation readings in the bottom chart range from +1 to -1. A positive number indicates a positive relationship while a negative number shows an inverse one. Notice that the majority of the readings are below 0.
Year-to-date, the VIX is up over 15%, but it doesn’t mean you should go out and start buying just yet. We need to look at the bigger picture to get a sense of what’s going on.
Reading Between The Lines
The VIX is a way of predicting the likelihood of price changes within the next 30-day period. It’s calculated as a percentage and then annualized to give us the expected change. It’s expressed as standard deviation, meaning that it represents a 68% probability of the change occurring.
Here’s how this works: VIX% / √(12)
The VIX currently stands at about 16. We take that as 16% divided by the square root of 12 which gives us roughly 4.62%. So it tells us within a 68% probability that the market will move less than 4.62% over the next 30 days.
Two weeks ago, the VIX was about 12. So we know that the change predicted then was only 3.46% for the following 30 days.
It helps to understand the full range of the VIX to understand what a sudden increase tells us. There are two key levels for the VIX that are considered the threshold for bullishness or bearishness. A reading of 20 or less is considered low, meaning that the market may be overvalued and ready to fall. A reading of 30 or higher means the market may be undervalued and ready to rise.
If we look at the VIX compared to the S&P 500 over the past 10 years, we can see the inverse relationship these indexes have. The average reading of the VIX over the past 30 years is about 19.
Since November of 2011, the VIX has not risen above 30 and has been above 20 only a handful of times in the last couple of years, nearest of which was February of 2014. That means market volatility has been giving an overvaluation signal for about 2 and a half years. Taking into account the length of the bull market, compared to its average length and the economic uncertainty in the rest of the world, it could be a good time for hedging strategies.
How To Trade The Volatility
Value stocks may be harder to find in this market, but they are still out there. Growth stocks are the most vulnerable to shifts in volatility so investors should be extra wary of them.
The sectors that should do well are the ones with the lowest beta like utilities, consumer staples, and other non-cyclical sectors. However, it doesn’t mean that sectors like technology and industrials should be completely avoided. Hedging becomes much easier when volatility jumps.
Thanks to higher volatility, the premium on options has risen. Increased uncertainty makes it more expensive to speculate on buying puts and calls, but it also makes shorting them more profitable.
Covered calls will help reduce the downside risk on stocks you own, while providing you with extra income. Put selling will allow you to speculate on value stocks, while taking in an upfront premium. Options that result in a net credit rather than a net debit will buffer your portfolio against adverse price movements.
As volatility increases via the VIX, investors should keep a close eye on that key level of 20. If it crosses that barrier, the increase could be seen as a positive sign that the bull market still has room to run and any correction should be seen as a buying opportunity. Watch out for dramatic drops in the VIX though. It may lull you into thinking the market is free of uncertainty, but it could be a sign that the bull market may finally be at an end.
CEO, Elite Wealth Management
Full Disclosures: http://elitewm.com/disclosures/
This article is not intended as investment advice. Elite Wealth Management or its subsidiaries may hold long or short positions in the companies mentioned through stocks, options or other securities.