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.

Finweek English Edition - - MARKETPLACE - Edi­to­rial@fin­week.co.za Schalk Louw is a port­fo­lio man­ager at PSG Wealth.

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.

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