There are more certainties in life than just death and taxes. For instance: If you invest money in the stock market, you certainly will face market volatility now and then.
Periods of high volatility are normal. Investors need to understand that life – and markets – will go on. And they can be just as profitable as before.
Time for lower expectations
What do the crash of 1929, the crash of 1987 (Black Monday) and the 2007-09 bear market have in common? Somebody made a killing by buying low when everyone else was worried about volatility.
Right now, everyone is abuzz over this year’s dark turn toward high volatility. But think about this: The Standard & Poor’s 500-stock index (.SPX) now trades where it was last November, and things seemed rather bright back then.
We have to put the early 2018 roller-coaster in perspective. Investors who bought at the 2016 election still have gains in excess of 20%. And those who bought when this current bull market leg began in February 2016 – just more than two years ago – still enjoy gains greater than 40%.
What exactly is volatility?
Without getting too deep in the weeds, volatility is a measure of how far prices move around. When volatility is low, stock prices move a little each day and there is not much for the evening news to feature. It is not very exciting to report that International Business Machines (IBM) closed higher by 10 cents.
However, low volatility does not mean investors cannot make any money. Just look at 2017, which was one of the lowest-volatility years on record. The S&P 500 gained 21.83% for the year, not including dividends. That’s one of the better annual performances we’ve seen; not top 10, but still pretty good.
Low volatility means the market is either not moving at all or is trending – higher or lower – very smoothly. Smooth rising trends are great for investors, although not so great for short-term traders.
Most people look at the CBOE Volatility Index (aka the VIX) (.VIX) as the main gauge of volatility.
Theoretically, this index measures traders’ expectations of price fluctuations over the next 30 days. It does this by looking at the premiums – or prices paid – for near-the-money options on the S&P 500 index. The higher the prices paid, the higher the VIX.
Typically, options prices climb when traders and investors are more fearful. This is what gives the VIX its nickname the “fear index.”
The index has no boundaries, meaning there is no one level at which we must conclude fear is so great that we must take some action. However, in practical terms, we usually see a range between 15 and 30. That means the expected price fluctuations for the next 30 days, on an annualized basis, is between 15% and 30%.
If you want to know the math, divide the VIX by the square root of 12 to find the expected price move over the next month. A VIX of 15 suggests the market anticipates a price move of 4.3%. A VIX of 30 suggests a move of 8.7%.
At major market bottoms, we usually see the VIX spike to the 30 level or even higher. Unfortunately, a very low VIX is not a good indicator of market tops. For most of 2017, the VIX stayed below 15 and even spent a good deal of time below 10.
The VIX did spike higher than 30 this year during the February shift into correction mode, but it quickly fell back to a range of 14 to 26. Aside from a few days in February, the VIX has traded in a rather normal historical range this year.
Still, it means the days of unusually low volatility are over. The market in 2018, by this measure, is actually back to normal.
John Bollinger, founder of growth-oriented portfolio manager Bollinger Capital Management, says volatility comes in cycles. Periods of high volatility give way to periods of low volatility, and vice versa. This is one of the principals behind the charting tool called Bollinger Bands, which directly measure the market’s volatility.
It was no surprise that the low-volatility era would eventually end, and because it lasted so long, the new higher-volatility period may look a little scarier than it should. But even this period will eventually end, returning the market to a lower-volatility state.
It may happen soon, or it may happen much later in the year.
Using volatility to your advantage
To borrow from former President Franklin Roosevelt, “the only thing we have to fear is fear itself.” Volatility and the fear index may signal trouble in the market, but at the very same time they can signal opportunity.
For instance, the extreme calm of 2017 suggested that a rather violent reaction would happen eventually. The problem is that many people lost their shirts betting against the bull market simply because it was “too calm” or long overdue for a correction.
However, armed with the knowledge that volatility cycles from low to high to low again, an investor might have been ready at a moment’s notice for when the VIX did finally spike higher. That means selling an underperforming stock right away or at the very least waiting for clarity before committing any new money to the market.
'Goldilocks' economy lifts markets
But here we are in April, well after the market started falling. How do we profit from volatility now?
Again, the market eventually will calm down. If you think the underpinnings of the economy are strong and there are individual stocks you think still are leaders in industries that remain critical to everyone (cloud computing comes to mind), then here is a great way to make money when everyone else panics:
It was British nobleman Baron Rothschild who coined the well-used phrase, “The time to buy is when there’s blood in the streets.” Of course, he meant that figuratively. The advice is, when everyone else is heading for the exit doors en masse, seek out the resulting great bargains.
Josh Brown, CEO of Ritholtz Wealth Management, shared his strategy in August 2015, when global stock markets were in freefall, sparked by an 8.5% drop in China. The VIX spiked above 50 and the headlines talked of panic.
He wrote down a list of five or six of the best stocks in America that he either missed buying or wished he owned more. At the time, he mentioned stocks including Facebook (FB) and Disney (DIS). In today’s market, that could mean Amazon (AMZN), Apple (AAPL), Alphabet (GOOGL), Nvidia (NVDA), Visa (V) and a few others.
He then went to his brokerage account and entered “good ‘til canceled” (GTC) orders to buy them at what he called “utterly absurd prices.” That meant perhaps 20% below where they were trading that day. And those prices were already down considerably from their recent highs.
If the correction got worse, he would own the country’s top names for a song. And if the market rebounded, no harm, no foul. Remember, if the market rallied back, you’d still own your other stocks.
The point is that volatility happens. And after spoiling us with last year’s low-volatility environment, the market actually just returned to normal this year. It may cause temporary sleeplessness, but it also can create big opportunities.
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