Why is this? Stock market volatility, as measured by the VIX, is a mean reverting measure, which means that what goes up must come down, and what goes down must come up. So with recent volatility levels in the mid-20’s, and the historical average volatility around 18, you can expect a drop. When it will drop is anyone’s guess.
Why is volatility mean reverting? It is the human condition. Our ability to adapt to fear and uncertainty requires ever-higher levels of fear and uncertainty in order for volatility to stay high. Similarly, when volatility is low, our skepticism and uncertainty tells us that bad news is just around the corner, and it takes ever better news for volatility to remain low. Unless the human condition changes, volatility will remain forever going above the magic 18 level then below, then above, then below for as long as we care to measure.
Now that you have a background on volatility, let’s look at the recent past. The stock market is currently well above the average volatility over the last 20 years but well below periods of extreme volatility. Under no circumstances could we classify the last week or two as a market that exhibits extreme volatility. In fact, the market was almost twice as volatile for a short period in August of 2015. That was less than six months ago.
The stock market over the last week or two has seen an orderly move down and it has been reflected market by an orderly increase in volatility. This is what makes the recent period unusual. Volatility isn’t exactly orderly. It has a tendency to overshoot, which means the interpretation of the recent events tells us that investors see bad things coming, and they can understand and quantify what they see; or at least they think they can. While the market’s forecast is not good, what investors see is more predictable; otherwise volatility would be significantly higher than what we’ve recently experienced.
Many years ago, our secretary of defense said there are things you know, things you don’t know and things you don’t know you don’t know. Right now, the markets are telling us that investors know what to expect and while they don’t see a rosy outlook, the reason volatility is higher than average is that they can see it with a higher degree of certainty than usual.
So is volatility good or bad for your portfolio? High volatility is always bad for your portfolio, because the market is going down. The facts are indisputable when it comes to this.
Using monthly Morningstar data from 1926 through the present, we observed two facts:
Fact No. 1:
Volatility is more than 50 percent greater during periods when the stock market is below its 12-month simple moving average.
Fact No. 2:
Almost 100 percent of all profits made since 1926 in the stock market were made during the 70 percent of the time when the market was above the 12-month simple moving average.
Combine these facts and calculate the 12-month simple moving average and the market is telling us to be defensive. Accordingly, for our wealth preservation clients where volatility is their enemy, we have the lowest allocation to stocks since August of 2009. However, we have two types of wealth-creating clients. This first type of wealth creating client recognizes that volatility is their best friend and embrace it. These clients are always in the stock market and looking for the best opportunities and can withstand 40 to 50 percent of temporary market losses. The second type is more risk averse and in their case, we also have the lowest allocation to stocks since August 2009.
Our advice? Know what type of investor you are and classify the types of market environments. If you do this, you will always know how to act in any environment.