I recently had LASIK eye surgery. During the brief 20 seconds my eyes were being exposed to the "Jimi Hendrix light show" as my doctor put it, I held my breath the whole time. The doctor even had to tell me to breathe normally.
Think of markets in terms of the breathing patterns of a human being. When we're anticipating pain or stress, we hold our breath until the pain is over. Then we breathe out, way out, and expel all that worry from our body when the worst is over.
The US financial markets may have just exhaled. The volatility index is often called a fear gauge because it usually rises as more out of the money put protection is being bought to protect long equity positions from further losses. That is like the market holding its breath. When the worst is deemed over as stocks recover, the market breathes out and volatility plunges. This happens in major cycles that span years as well as short term cycles that span days or weeks.
Looking back at all the data I have on the VIX 10 day moving average, you can see very clear patterns emerge. The VIX tends to either be in one of two states:
- Highly volatile - VIX regularly stays above 20 and doesn't stay too long below.
- Not volatile at all - VIX regularly stays below 20 and rarely stays above.
The yellow highlighted period represents the market breathing out. This stage is triggered when the VIX 10 day moving average stays below 20 for more than six months. As you can see, it can last for years. The blue highlighted period represents the market breathing in. This stage is triggered when the VIX 10 day moving average stays above 20 for more than six months. The market just entered a new low volatility era.
The first thing you'll notice is that when we're in the low volatility era (yellow), markets tend to move much more slowly but generally higher over time. Interestingly, things begin to go parabolic right before the next volatility era. Take for instance 1995-1997, where suddenly the markets began to move quickly higher. One immediate lesson to learn is that parabolic stock price action should be met with skepticism if you're a bull. Big melt ups in the market will occur at the beginning and end of a trend. The middle will be a lot sloppier.
The next thing to notice is that given the slow market action during periods of low volatility, gains might not come for quite some time, therefore, it would be prudent to focus on yield over highly leveraged index long positions. Furthermore, it would be dangerous to buy out of the money index calls that with short term expirations, since price swings are not very large in either direction. It would be even more dangerous to hedge using put options, because corrections are few and far between. If you can time them perfectly, you would be lucky to get a 5% correction.
Is it even worth bothering when the VIX stays this low this long? Probably not. That's why I've devised a model that suggests a 100% long position during these low volatility time frames, with a dividend reinvestment plan.
During the high volatility periods, it's clear that the markets tend to move sideways or down, so it no longer makes sense to be 100% long without a hedge. That's why I devised a *suggested* allocation model that reduces long exposure when volatility rises, and increases it as it falls.
The model looks like this (as an example):
VIX 10 day avg < 20 for more than 6 months (current situation)
100% long allocation with no hedges, no trading and dividend reinvestment.
VIX 10 day avg > 20 and < 30
- 60% long
- 35% cash
- 5% for hedging
The 35% cash will be used to re-enter if volatility begins to fall. The 5% hedging allocation can be used to reduce losses were volatility to climb even higher and stocks fall even lower.
VIX 10 day avg > 30 and < 40
- 50% long
- 40% cash
- 10% for hedging
The 40% cash will be used to re-enter if volatility begins to fall. The 10% hedging allocation can be used to reduce losses were volatility to climb even higher and stocks fall even lower.
VIX 10 day avg > 40 and < 50
- 25% long
- 60% cash
- 15% for hedging
The 60% cash will be used to re-enter if volatility begins to fall. The 15% hedging allocation can be used to reduce losses were volatility to climb even higher and stocks fall even lower.
VIX 10 day avg > 50
- 0% long
- 90% cash
- 10% for trading
In this case, you wouldn't want to be too involved in the markets except maybe a small amount set aside for trading the volatility and taking advantage of the big swings. A market like this might be too "scary" to really be involved with, long or short.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.