The time has come again when investors are faced with a tough question whether this market downturn will be just a mild correction or a more serious downfall like the one that happened back in 2011 or even 2008/2009. The fear and greed conflict in every one of us investors is never-ending, and at times can be excruciating. It is exactly during these times, when the VIX volatility index spikes over 20 that we should remind ourselves that we are in for the long run, and resist the fear that urges us to sell. The biggest mistakes investors make is selling impulsively in panic. The second biggest mistake is investing on margin, as I wrote back in April in an article titled "How to profit from market meltdowns."
The key takeaways of this article is to buy when others are fearful, and always have some cash at hand to take advantage of pullbacks in your favorite stocks. Additionally, investors can take advantage of the falling volatility after the turmoil.
Should you invest now? Yes, but choose stable, defensive stocks
My advice is definitely to keep holding what you already own. But what about buying more at this time? If you have some extra cash from recent dividends or otherwise, invest in the best stocks that can be bought at a discount during a turmoil like this one. My favorite stock/fund, Berkshire Hathaway [(BRK.A), BRK.B)] is down 7% from this year's top. Berkshire has tons of cash to the tune of $40B to $50B and will benefit from the pullback because it will be able to find large undervalued companies ripe for a takeover or sell some more index puts at lower strike prices and higher premiums, benefiting it in either case, whether the puts are called and Berkshire ends up owning an index at a huge discount, or if the now fatter premiums stay in Berkshire's pockets while expiring out-of-the money. Due to the company's size and stocks' full valuation it has recently been unable to strike any really large and meaningful value deals since Heinz. Chevron (NYSE:CVX) is down likewise. Exxon (NYSE:XOM) is 10% cheaper than at the top earlier this year and yields almost 3% annually in dividends now. I explained why Exxon is on my buy list back in May. These are the three positions to which I will be adding any free cash that presents itself to buy into this pullback. Market valuations of these three and many other companies are not frothy, but rather fairly valued or even slightly undervalued. Take Berkshire, for example. It trades at 15.6x trailing earnings. This is hardly a bubbly territory. Or Chevron at 9.55 trailing P/E and paying a 3.4% dividend. Exxon trades at 10.82x trailing earnings and pays a 2.93% dividend. There are still many fairly valued and undervalued stocks to choose from. We are not Berkshire that needs to buy in Billions of dollars. Moreover, the falling dollar could ignite a surprise earnings rally.
How to profit from volatility falling back
I would like to share with you one more investment idea, which is shorter-term in nature. Investors who believe as I do that the current high 20+ VIX will fall back to the mid teens as time passes by, can either short the volatility ETFs, such as the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX), or buy inverse volatility ETFs, such as ProShares Short VIX Short-Term Futures ETF (NYSEARCA:SVXY). Investors can use put options if the ETF/stock cannot be borrowed.
During most of the post-2008 occasions, the volatility spikes over 20 have never stretched too high over 20 and have fallen back below 20 relatively quickly, within a few months, as one can see from the VIX chart below. However, this does not guarantee that this will be the case now. Statistically, it just illustrates that it is advantageous to position yourself for a VIX fall from above 20.
Word of warning on VIX products
When trading volatility products, investors always risk negative or positive effects of contango. Hence, when the spot volatility is higher than the longer-term volatility contracts, backwardation occurs, causing long VIX products, such as VXX, to gain even if volatility stays the same or slightly falls back. Similarly, inverse volatility products, such as SVXY, can lose value even as VIX stays flat or slightly falls. Investors need to have a long-term view and wait for the contango to kick in and the VIX to fall back way below 20 to take profits. Investors should resist the seeming temptation of leveraged (2x, 3x) ETF products as they can lose value even under conditions under which the same non-leveraged product gains or remains flat.
Prior to the 2008/2009 crisis and the ultra easy money policy, there have been long stretches before with volatility trading above 20 for extended periods of time.
Should you wait in hope of a further drop in stocks?
I am not a fan of market-timing strategies, with a few exceptions. Hence, even though it is possible that the market will keep falling due to the debt ceiling gridlock, I prefer to simply evaluate stocks in terms of their valuation and based on that decide whether to buy or not. Bottom-fishing or market-timing doesn't always work reliably. Investors could be caught by surprise by a rebounding stock market.
Long-term investors should not be scared during downturns and view them as a buying opportunity. However, high quality, defensive titles are recommended. Smart investors are also never forced to sell when the conditions are not ideal for them, such as due to a margin call or impulsively as a result of the stress caused by incurred unrealized losses during downturns.