Bear Market Investing: Brace Yourselves

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Includes: VXX
by: FundGuru

Summary

The VIX, often referred to as the "fear gauge", is the market's expectation of near-term volatility.

It has dropped an astonishing 32% in March, down to levels last seen in the summer of 2015.

This monthly pace of decline was the fifth fastest on record since 1990.

Periods of low volatility tend to be followed by higher ones, and investors should not get too comfortable.

What is the VIX?

As per Investopedia:

The VIX (CBOE volatility index) is the ticker symbol for the Chicago Board Options Exchange Volatility Index, which shows the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking and is calculated from both calls and puts. The VIX is a widely used measure of market risk and is often referred to as the "investor fear gauge."

Has The VIX Fallen Too Quickly?

At at March 31, 2016, the VIX index was sitting at 13.95, not too far off what is considered the rock bottom level, about 12.50 over the past 5 years.

That decline translates to a month-over-month fall of -32%, placing it in fifth place in terms of magnitude since February 1990:

That is a big drop. As one can see, periods of low volatility never lasts for too long and tends to be followed by periods of higher ones:

^VIX Chart

^VIX data by YCharts

Why Should I Care?

The VIX is not set by any one person, but rather from the collective actions of all financial market participants, including short-term traders to long-term investors. Higher VIX implies higher premium on options, a sign of higher financial market stress or investor nervousness. This causes greater gyrations in the equity market. Volatility is not good for share prices, and the two are inversely correlated. This is the correlation between the VIX and S&P 500 returns over the past 3-, 5- and 10-years:

Correlation to S&P 500
3 Year -0.74
5 Year -0.74
10 Year -0.68

Since 1990, the VIX level has only been below 14 approximately 25% of the time. For the past 5 years, the VIX has hovered around 16, some 15% above current levels. Over the long-term, its average is 20, some 40% above current levels.

Below is the average monthly returns of the S&P 500 corresponding with different % changes in the VIX level:

  • VIX jumps 50+%: -8.6% (range: -16.8% to -2.0%)
  • VIX jumps 40-50%: -4.1% (range: -9.0% to -0.3%)
  • VIX jumps 30-40%: -2.5% (range: -8.4% to +5.1%)
  • VIX jumps 20-30%: -3.9% (range: -10.9% to +2.3%)
  • VIX jumps 10-20%: -1.0% (range: -8.4% to +5.2%)

Although increases in the VIX tends to be very sudden, it may not come in a single month. It could increase over the course of a few months.

Using VIX To Your Advantage

VIX values greater than 30 are generally associated with a large amount of volatility as a result of investor fear or uncertainty, while values below 20 generally correspond to less stressful times. Accordingly, investors may want to consider decreasing equity exposure after a period of low volatility, and gradually increase risk after a sudden surge in volatility to levels above 30, as the stock market would likely have gone down sharply.

We believe the recent sharp drop in the VIX is a sign that investors are once again getting too optimistic too quickly, a poor reflection of today's fragile macro environment and heightened valuations in some markets. Calm waters never last for too long in the financial markets, and we recommend all investors not to get too comfortable.

For additional reading, we welcome readers to check out these articles in our Bear Market Investing series:

Disclosure: I/we 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.