By: Schalk Louw, Wealth manager at PSG Wealth
It’s always darkest before the dawn, and markets across the globe are looking pretty dark right now. I’m not saying that the worst is over, or nearly over (my crystal ball is simply not giving me any clear answers) but if you look at the past, history will remind you that following the herd and selling up due to panic are not sensible strategies.
So, what can you do instead? A great tool to turn to in times of high volatility, is the volatility ratio (VR), as represented by the Chicago Board Options Exchange (CBOE) volatility index (VIX).
Investors can use volatility not only to determine risk, but also to point out possible investment opportunities and dangers. Volatility is not a directional indicator, but rather a measure used to express changes in pricing as a percentage. If share A’s price rises from 100c to 101c, it indicates a positive change of 1%. If share B’s price moves from 200c to 198c, it is seen as a negative change of 1%. The VR of both of these shares is the same (1%), therefore the VR of share A is equal to that of share B.
The VR can be used to determine the risk of a particular investment. When an investment in a particular share, for example, has a VR of 20, it means that the investment has already moved up and down by 20% during the period in question. This means that if you do decide to buy this share, you don’t only have an opportunity to grow your investment by 20%, you also risk losing 20% of its value. The lower the VR, therefore, the lower the risk, or so it seems.
What this actually tells us, is that emotions play a massive roll in the decision-making process during times of high volatility, and investors then have the tendency to force the market to levels well below its fair value. In times of low volatility on the other hand, investors are so confident that the market will not drop to lower levels that they force it upwards – a lot like the market has behaved during the last 12 months.
The US stock market has always been considered as being in completely oversold territory when the VR reached levels of above 40, while it is considered as saturated when it moves closer to 10.
Until recently, we have seen the VIX trading at levels of around 10% on a regular basis and investors simply refused to believe that the S&P500 could experience a decline. The Coronavirus outbreak, however, has brought this to an abrupt halt. The S&P500 declined by 13% between 14 and 28 February 2020. And so, for the first time since September 2011, the VIX has closed above 40% at month-end.
In fact, since 1992, we have only seen the VIX close month-end at above 40% eight times. These included:
- A massive market collapse in 1998;
- The build up towards the war in Iraq at the end of 2002; and
- The Great Recession and market collapse of 2008.
In each of the eight instances where the VIX measured above 40%, it was backed by good reasons. Were any of these reasons good enough to sell your shares, however? Most definitely not.
The S&P500 Index delivered the following average returns over the following periods after each of the eight occurrences:
- 6-month returns: 20.5%
- 1-year returns: 30.9%
- 2-year returns: 50.6%
As mentioned before, investors shouldn’t use the VR as a directional indicator, but rather to determine risk and a possible overreaction to market events. And if historical data shows us anything, it is that now is the time to remain cool, calm and collected. Don’t let your emotions and the herd’s actions dictate your decisions.