Major stock market indexes like the Standard & Poor’s 500, Dow Jones industrial average and Nasdaq composite are near all-time highs despite geopolitical uncertainty.
Meanwhile, volatility measures, like the CBOE Volatility Index, known as the “fear index” is at its lowest level in 10 years.
Simply put, volatility is the number of up-and-down days for the market. The wider the swings are in those trading patterns, the more volatile the market. But equities have been rising steadily. Except for a few small spikes, the so-called fear index, or VIX, has been sliding since mid-2015, even though geopolitics have been anything but tranquil. Normally the stock market doesn’t like uncertainty, but it’s been fed a steady diet of surprising news and hasn’t suffered indigestion.
[See: 13 Ways to Take the Emotions Out of Investing.]
A market head-scratcher. Record stock market values and ultra-low volatility have left many market watchers perplexed.
“Volatility has been exceptionally low, and it’s been puzzling most people given that’s its usually a fear gauge,” says Peter Andersen, chief investment officer at Fiduciary Trust Co. in Boston.
Andersen points to European terrorist incidents and election uncertainty, weapons tests by North Korea, and the uncertainty surrounding President Donald Trump as a few reasons why stock traders would ordinarily be jumpy.
On a few recent occasions, volatility has come to life because of unexpected news, such as when Trump fired FBI Director James Comey. The Dow fell 300 points and the VIX gauge spiked 50 percent in a day. But the Dow rebounded a day later, and the VIX slumped again.
Mark Stoeckle, chief executive officer and senior portfolio manager at Adams Funds in Baltimore, says that from a market perspective all the recent news has been “a big yawn,” though he concedes it’s odd.
“To me, what it could be signaling is, in order for the market to really care, it’s got to be something bigger,” he says.
It won’t last. Although volatility is at historically low levels, it won’t last. The stock market has been in cruise control for so long that “there is a high sense of complacency,” says Todd Burchett, managing director of portfolio management at Athena Capital Advisors in Lincoln, Massachusetts. “If you look at the survey data, everyone is quite optimistic.”
Investors may be complacent because central banks — including the European Central Bank, Bank of Japan and People’s Bank of China — have monetary policies that support the market. Plus, he says, there is still a lot of cash on the sidelines held by private equity funds, mutual funds and other big institutional investors who swoop in on down days.
Prepare for the inevitable. With the market calm, now is the time for investors to consider how their portfolio would stand up to a sharp drop in prices.
“Take a look at your portfolio and stress test it against last January when the market was down 10 percent,” Burchett says. “Are you going to change your behavior when that happens?”
The worst thing an investor can do is sell based on short-term spikes in trading, Andersen says.
“If you’re watching your portfolio frequently in a period of volatile markets, you’ll see variable valuations of your portfolio,” he says. “It can cause you to get sidetracked, lose focus and discipline, and consider selling because you might think it’s a signal of a bear market. That’s the biggest danger, I think.”
[See: The Fastest Ways to Lose Money in the Stock Market.]
Being broadly diversified can help ease volatility because short-term market swings can affect some sectors more than others. Keeping the big picture in mind by reviewing the reason for the portfolio’s asset allocation helps investors keep their cool when volatility spikes.
Some exchange-traded funds seek to buffer investors against price swings, such as iShares Edge MSCI Minimum Volatility USA ETF (ticker: USMV), which attempts to pick stocks with the least amount of risk.
Stoeckle cautions against investors betting tactically on volatility. “There are market professionals trying to do it and not doing a very good job of it,” he says. “The average investor would be making a huge mistake trying to time volatility.”
Most exchange-traded products that seek to take advantage of volatility are down sharply this year, such as the exchange-traded note with the most assets under management, iPath S&P 500 VIX Short-Term Futures ETN ( VXX), which is down 47.2 percent this year.
Burchett says investors who want to hedge against volatility with new investment money could buy call options against the major indexes, such as a call option against the SPDR S&P 500 ETF ( SPY).
Call options are the right, not the obligation, to purchase the index. These options are cheaper now because implied volatility is so low. Call options will help limit losses if prices fall, he says.
Andersen says investors can take advantage of short, sharp spikes in volatility by having some cash on hand to snap up securities that drop in price. Make a plan now to buy on down days and not get caught up in the selling frenzy.
[See: 10 Tips for Keeping a Cool Head in a Market Meltdown.]
“If a week from now this happens, you execute the plan,” he says. “You do it cold blooded. Don’t think about it, or the negative news that’s coming out of the media at that point.”
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The Time to Prepare for Volatility Is When It’s Low originally appeared on usnews.com
