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Market Research - May 28, 2019

Harness Volatility & Create Opportunity

While the VIX has long served as a volatility yardstick for investors, the index stepped into the limelight at the beginning of 2018 when it spiked to its highest level since mid-2015. The VIX cooled off for a time, but as we rolled into 2019, volatility returned. Just as was the case last year, investors are needing to tap into their fight or flight instincts. And while you may be tempted to choose the latter, there’s a case to be made for fighting through volatility.

First, a quick VIX crash course. The VIX measures the implied volatility of the S&P 500, but it isn’t calculated using the prices of the equities that make up the index. The level of the VIX is actually determined by the number of options contracts bought and sold on those underlying securities — an indication of hedging and bearishness, but not necessarily a sell-off.

Despite, and in part due to recent volatility, the chart below shows that major indices are only slightly higher over the past year. This illustrates that volatility more so means variability, and not necessarily losses.

Volatility can be a scary thing — but this doesn’t have to be the case. Because of record-high returns and record-low VIX levels during the market’s historic bull run, investors have developed rosy expectations for both of these metrics. In reality, the average VIX level since its introduction in 1993 is about 19.3; the average so far in 2019 is just 15.8; so while volatility feels high in comparison to recent years, the VIX is still below its average level.

So why does it feel like the markets have never been more volatile?

According to TD Ameritrade’s Investor Movement Index, retail investor exposure reached a record-high level at the end of 2017. As every stock went up, everyone bought; as everyone bought, every stock went up. The VIX levels in 2018 and 2019 seem so high simply because there are more people taking part in the conversation. While the VIX reached record lows in 2017, the SPX/VIX correlation has since returned to its historical level.

The chart below shows a bull market spanning 5 years. 2017 and the middle half of 2018 were uncharacteristic in that the bull market persisted with very little volatility; as of today, the market has returned to historically normal levels of uncertainty.

The storylines driving today’s volatility are all familiar sound bites: the market is unsure about future interest rate decisions as lowering rates becomes a possibility; the US-China “Trade War” has caused analysts to adjust their models as the cost of inputs for US businesses increase; and more than a few of the major IPO’s in 2019 have fallen flat after their debuts.

So what does all this mean for you — an investor?

It might be time to rethink those ETFs that have delivered 10%+ annual returns coming out of the Financial Crisis. Fund managers are chomping at the bit as the darling index-trackers slip, but herein lies an opportunity for stock picking. As the old adage goes, “When the VIX is high, it’s time to buy.”

By changing your perspective on volatility, you might see it as an opportunity to dive deep on equities, looking for those with solid fundamentals that recently sold off. With investors actively taking opposite positions on any single equity — a rare occurrence in the last 10 years or so — fundamental analysis and market monitoring are as important as ever for timing buys and sells. As an individual, though, it’s especially important to consider retail transaction fees — which are relatively high, on a percentage basis, for individuals.

Volatility may be here to stay, but it’s not synonymous with losses. Finding the winners of 2019 may require a little more digging, but they’re still out there.

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