The dangers of simply following the herd
A market’s volatility index should be used as an indicator of potential risk, not of the possible direction the market could be moving in.
as I was writing this, we have been rewriting history books daily in the sense that up to 14 March this year has been the longest period since 1995 that the S&P500 Index, on a consecutive trading basis, has not seen a decline of 1% or more.
They say that when the good times are rolling, you should roll right along, and although this doesn’t really offer much of an answer to the many questions posed by investors today, it does offer a good example of what you shouldn’t necessarily be doing. Sometimes it’s better to listen to the cautious voice in your heads and not follow the rest of the herd. I’m definitely not calling this the market’s peak level and my crystal ball remains hazy on the subject, but I would like to suggest taking a look at the past and trying to figure out how it fits into a future that’s definitely no longer as positive as currently reflected in share prices.
An excellent tool to use in times of great volatility is the volatility ratio (VR). Each time that the volatility index (VIX) of the Chicago Board Options Exchange (CBOE) moved to levels above 45, it was seen as the greatest buying opportunity in the market ever. It remained that way until it moved back down to levels of around 10, which indicated a possible turning point in the market to investors.
Before I continue, I first need to define volatility and explain how it can be used not only to determine risk, but also to identify possible investment opportunities and danger zones. Volatility isn’t a directional indicator. It is a measure that expresses price changes, whether up or down, as a percentage. Let’s say that share A’s price rises from 100c to 101c, for example, then this would indicate a positive change of 1%. If share B’s price falls from 200c to 198c, it would indicate a negative change of 1%. The VR (of 1%) of the two shares are the same, which means that the VR of share A is equal to the VR of share B.
The VR is a great tool to determine the risk of a specific investment. If an investment class such as shares, for example, has a VR of 20, it means that this investment’s price has moved up and down by 20% over the period in question. As a result, by buying this share, you don’t only stand the chance of 20% growth on your investment, you also risk losing 20% of its value.
The lower the VR of an investment, the lower the risk, or so it seems. What it actually tells us is that in times of high volatility, emotion plays such a huge role in investors’ decisions that they actually force the market to lower levels than its fair value indicates. In times of low volatility, investors are convinced that the market cannot fall to lower levels, forcing it upwards, just as it has been happening over the past 12 months.
The US market was always regarded as completely “oversold” once the VR reached 45 and above, while it was considered close to saturated as it moved closer to levels of around 10.
The last time that our market reached a VR of around 10 was shortly before the great correction of 1998, and we know how that ended: with a near 50% decline in US dollar terms, and the VIX far above 45.
The last thing I would want to do this week is to cause panic, but with the S&P 500 on the same route for the past 105 trading days, the VIX has been trading at the same levels as in 2008. It just so happens that the last time that the SA Volatility Index (SAVI) traded at levels similar to the VIX’s current levels was in June 2014. The result since then: almost no growth for nearly three years.
As I mentioned before, the VR shouldn’t be used as a directional indicator. Rather use it to determine risk or an overreaction in the market.
It doesn’t matter how you use the stock market as an investment vehicle, as long as you do your homework properly. More importantly, make sure that by following the herd, you don’t end up biting off more than you can chew.
It doesn’t matter how you use the stock market as an investment vehicle, as long as you do your homework properly.