The stock market and professional sports have plenty in common. You can build complex statistical models that attempt to predict the winners and losers, but there are no guarantees, only surprises. Like Nashville making this year’s Stanley Cup finals. Or that Tesla’s market capitalization would exceed that of General Motors?
The puzzle of low volatility
Low volatility in global stock markets in recent years has confounded many market watchers. Typically, the longer the stock-market rally, the greater the expectation of a correction, but that hasn’t happened this time around. Investors appear to have become more complacent, not less, late in the current cycle.
What does volatility mean for investors? Simply put, when volatility is low, stock prices vary less around their trend line: day-to-day movements in prices are less dramatic. In contrast, high volatility means greater risk and greater potential returns for investors, with opportunities to buy underpriced assets and conversely to take profits. Past volatility is old news – what investors want to know about is future volatility, and specifically, if there is a market correction on the horizon.
The most widely-used market measure of expected volatility is the Chicago Board Options Exchange’s forward-looking volatility index – VIX – also known as the “investor fear gauge” for the S&P 500. VIX tracks implied volatility (rather than historical trends) based on how options on the underlying index are currently trading. Volatility, as measured by VIX, has trended sharply lower in recent years and is hovering at levels not seen in more than two decades. After a spike in early July 2017, this volatility measure hit new lows mid-month.
The current low levels of VIX have been cited as both justification for the continuation of the U.S. stock market rally and as a signal that investors are deluded into thinking that a correction cannot happen. In other words, VIX is telling us precious little about where the stock market is headed.
Asset allocation is the key to success
What’s an investor to do? When in doubt, always return to your investor policy statement and check that your investment decisions match your goals and risk profile. If you invest with an adviser, check in to make sure your asset allocations are up-to-date and make sure you understand whether they are pursuing an active or passive investment strategy. Passive investors don’t react to a change in market outlook; active investors are more tactical – they may move to a greater cash or fixed-income allocation if they expect a stock-market correction.
For do-it-yourself (DIY) investors, the same advice applies: check that you are on track. Passive DIY investors would stick to their target asset allocation and ignore the noise. Active DIY investors who believe a market correction is imminent would take steps to reduce their stock allocation and increase their cash and/or fixed-income allocation.
Don’t sell low, buy low!
The probability of a market correction within the next two years is high, and many say virtually certain. What’s new this time around is that the percentage of DIY investors holding easy-to-sell exchange-traded funds (ETFs) is at a record high. Study after study has shown that the risk to investors is not the correction itself – markets recover in the long term – but rather selling low and locking in losses.
To be a successful investor, sit back throughout the bumpy ride. When you rebalance your portfolio post-correction, you will be underweight in stocks, so you will buy more at discounted valuations. Rather than selllow, you will buy low.
In the words of Yogi Berra, “If you don’t know where you are going, you might not get there.” No one can pinpoint exactly when a market downturn will happen, but everyone can prepare by making sure her current asset allocation matches her target. Are you ready for the roller-coaster ride?