What is the one belief that both a buyer and a seller have in common? This is a question that I love to ask new and seasoned investors we work with. Take a minute and think about that question, I’ll circle back to it a bit later. For now let’s focus on the question I have been getting a lot these days…”Is now the time to get excited about stocks or fear them?”
Despite all the predictions, no one can call a bottom. It is futile to use any of your time and energy for such an impossibility. Rather, if you believe that life will find a way to survive Covid-19 and if you believe people will pick up and dust themselves off, then the market will recover at some point and finding the bottom truly becomes a moot point.
Fear is running rampant right now. As a result, the increased market activity has caused the CBOE Volatility Index (VIX) to make record highs, surpassing previous historic levels last seen in fall of 2008. A year ago I polled my friends on Facebook asking if any of them had ever heard of the VIX. Less than 20% of those have ever heard of the VIX, which is what I anticipated.
For readers who are less inclined to know what the VIX is think of it as a kind of “Fear Index” for the market as a whole. It usually goes like this….something out of the ordinary panics the market and selling activity picks up. The higher the VIX goes the higher the relative market volatility (i.e. fear) and vice versa.
The VIX paints a psychological “picture” illustrating the fear herding mentality of human behavior. When faced with stress, our collective minds revert to knee jerk reactions that, in hindsight, often does more harm than good. For example, the sudden fear of Covid19 drove the masses to descend upon grocery stores to buy enough toilet paper and can goods to last a year. Why do you think they did that? I believe it is because the world suddenly came under enough emotional stress where logically-minded thinking can’t function. People are buying and hording toilet paper and other basic everyday supplies because that is the ONE thing they feel they CAN control right now. This illusion of control is a common driver of illogical decision making.
Getting back to my first question…What is the one belief that a seller and buyer have in common? The answer is simple; they both share the opinion that the price is wrong! Furthermore, what makes them believe they know more about what the price should be then the market does? From the vast majority of them, that belief is an illusion. Adding a layer of sudden fear and panic to the mix, what investors are doing is no different than hording toilet paper. As investors, they are hording cash by selling stocks. They think this is the ONE thing they feel they can control. They have abandoned logic and sound planning and are reacting to the fear of the unknown. The VIX has spiked, just has it has in the past during other uncertain and scary times. The financial media is all too happy to constantly parade the VIX level across media platforms. It is a huge “shiny object” geared to garner clicks, hits, and views.
This is where volatility and opportunity collide in way that could harm those who are not prepared. This is where following a disciplined and a sound investing process really does matter.
Is the phrase “Buy when there is blood in the streets” really true? If so, what does that quantitatively mean to average investors?
As explained, the VIX is a representation of the implied level of fear in the market. However, it can also be a tool to help identify opportunities that many others may be missing. A better question to ask and study is: Can the relative level of the VIX signal when stocks are more likely to outperform baseline normal returns? If so, what does that opportunity look like? Can it be quantified in a way to help formulate good options?
Chart 1: Daily Closing VIX (January 1st, 2004 to March 27th, 2020)
Chart 1 above captures the closing values of the VIX since January 1st, 2004. I have added horizontal lines to represent times when the VIX was above 40 and above 50. I picked these levels as they seem to represent levels of fear that have been associated with steep sell offs of 20-40%. The Covid-19 correction is presently within this range. The takeaway is that many of the previous 20-40% major market selloffs have coincided with the VIX surpassing 40 and sometimes even 50. As of March 27th, 2020, the VIX closed at 65.54 (reference Chart 1).
Chart 2: Source Nick Maggiulli, “Should you buy stocks now?” – March 18th, 2020
Nick Maggiulli recently wrote an excellent blog post that included this chart above. Using red dots, he illustrated previous times where the VIX surpassed 40 for the first time during previous turbulent times. Historically, the dots have often coincided with the market forming a near-term bottom.
In order to help investors better understand the relationship between the VIX levels and market returns, I reviewed such data between the time periods of January 1st, 2004 and January 2nd, 2019. I grouped the historical data into different absolute VIX closing levels (<20, 20+, 25+, 30+, 40+ and 50+). I then calculated and created heatmaps of the following:
1. The average S&P 500 returns (adjusted to include dividends) over the following 3, 6, 9, and 12 months after reaching a given level of the VIX
2. The historical "Success/Fail” ratio 3, 6, 9, and 12 months after reaching a given level of the VIX.
3. The worst returns over the following 3, 6, 9, and 12 months after reaching a given level of the VIX.
The average and median closing value for the VIX during this time frame was 18.4 and 15.7, respectfully. 3,776 market days were analyzed in this study. In normal market environments, the VIX is below 20
% of days studied where VIX closed below or above 20:
% of days where VIX closed at or above:
What is important to note is that extreme volatility (over 30) is not the normal volatility environment of the market. A normal closing value of the VIX is under 20, which accounted for 72% of the days studied.
Based upon the current VIX levels (50+) what we are seeing today happened only 1.48% of the time from January 2004 – December, 2018.
Heatmap 1 shows what happened once the “cause” of previous selloffs subsided and markets began to calm down.
Heatmap 1 above illustrates a strong tendency for the market to outperform the baseline “i.e. average” returns once big selloffs have subsided. As you can see above, the higher the closing VIX level, the higher the subsequent return as time passes. Big caveat here: There is no guarantee that the markets cannot selloff further once a threshold it hit. To clearly illustrate this caveat, look at the average returns 3 and 6 months after the VIX closed at 50+. It was not until 9 and 12 months later that the gains seem to show themselves.
Heatmap 2 illustrates the percent of the time a dollar invested in the S&P either increased or declined over the various time periods. Think of this as a trade “success/fail” ratio. For example, of the 56 previous days where the VIX closed above 50, after 12 months, 98% (55/56) of those unique trial periods finished higher.
So far, we have been looking at averages in the VIX study. What about the previous “worst case” outcomes from past events? Heatmap 3 captures the single worst historical return for each of the closing VIX groups.
The important lesson in heatmap 3 is this…losses can still mount no matter what the closing level of the VIX may be. However, at least from the past results, the relative magnitude of additional losses tends to decrease over time, especially for dollars invested at VIX levels of 40 and above. At 40+ VIX entry levels, the worst results were much better than the average results experienced during “normal” volatility times (i.e. 0-20 Level).
In Heatmap 1, the best historical 9 and 12 month returns were experienced in the 30+, 40+ and 50+ VIX levels. Heatmap 2 illustrated how the historical success/fail ratios improved over time at each closing VIX level. Heatmap 3 illustrated that, in the past, new money invested at the higher VIX levels tend to experience less downside loss than average, especially when held for 9 to 12 months.
Is this the time to buy stocks? That really depends on how long you plan to invest. It’s not about catching a bottom because no one knows when that will occur. For long-term investors who seek to buy low, this is certainly a time when stocks are much lower than they were just a month ago and volatility is very high. Here is what I suggest to do if you wish to act:
Invest Idle Cash: These times don’t come around very often. If you are in a position to put some new cash to work, then this would be a good time to consider doing so. Work with your financial professional and develop a disciplined buying process.
Rebalance Your Portfolios: If this recent selloff has lowered your stock allocation, it is time to rebalance. Sell enough bonds or add new idle cash to buy enough equities to get you back to your suitable target allocation.
Increase Savings Rates: If you are able to, increase your 401(k) contribution rate. Consider accelerating your yearly savings goals to invest that money today. You should also consider front loading your children’s 529 plans, IRA, Roth IRA, Health HSA or SEP IRA contributions.
What NOT to do:
Do NOT invest money that is for short-term needs into this stock market. Rule #1 The Market Owes You Nothing!
Do NOT invest your “safety” nest egg. If you don’t already have a safety nest egg of cash, this market selloff should reinforce the need to build one ASAP. Keep 6-9 months in cash to cover any short-term loss of income. Doing so will help you guard against invading your long-term investment accounts, especially during market corrections, giving them time to recover.
Do NOT borrow money to invest, don’t leverage your house, your car, your business, nothing.
Do NOT take on more risk that what is appropriate for your financial plan or more than what your risk tolerance will allow.
Let’s talk about the impact and opportunities of the recent volatility on your investment portfolio. Call me at 515-457-2930.
Definitions and Data Sources The Volatility Index, or VIX, is an index created by the Chicago Board Options Exchange (CBOE), which shows the market’s expectation of 30-day volatility. It is constructed using the implied volatilities on S&P 500 index options. This volatility is meant to be forward looking, is calculated from both calls and puts, and is a widely used measure of market risk. The VIX is often referred to as the "investor fear gauge.”
Historical S&P data is adjusted (for dividends and splits)
Past performance is no guarantee of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in the study will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Due to various market conditions, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information continued in this study serves as a receipt of, or as substitute for, personalized investment advice from Capital Resource Management, Diversified Financial Group, or FSC Securities. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her situation, he/she is encouraged to consult with the professional advisor of his/her choosing.