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Economy - April 25, 2018

How Research Creates Opportunity in Volatile Markets

2018 is the year of the VIX — everyone’s talking about it and most are afraid of it. For the first time in a while, 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.

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 the recent volatility, the chart below shows that major indices are nearly level with their 2017 end-of-year values. 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 in 2017, investors have developed rosy expectations for both of these metrics. In reality, the average VIX level since its introduction in 1993 has been about 19.4; the average in 2017 was 11.1; and the average for 2018 through today is 17.7; so really, 2017 was the outlier.

While 2017 looked a lot like Dr. Jekyll, it’s not entirely fair to label 2018 as Mr. Hyde. So why does it feel like it?

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 seem so high simply because there’s more people taking part in the conversation. While the VIX reached record lows in 2017, the SPX/VIX correlation has returned to its historical level in 2018. The chart below shows a bull market spanning 5 years. But even so, 2017 was uncharacteristic in that the bull market persisted with very little volatility; in 2018, the market is returning to historically normal levels of uncertainty.

The story lines driving 2018’s volatility are all familiar sound bites: the market is apprehensive about the timing and number of future interest rate hikes, still getting used to new Federal Reserve chair Jerome Powell; the US-Chinese “trade war” is affecting a new industry every day — ranging from steel to sorghum to semiconductors; and Facebook’s data privacy concerns have dampened both consumer trust and market sentiment in technology and social media stocks.

So what does all this mean for you — the retail investor?

It might be time to rethink those ETFs that soared in 2017. 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 2017 — 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.

We were all lulled into a relaxed state in 2017, but the new year jolted us awake. Volatility may be here to stay, but it’s not synonymous with losses. Finding the winners of 2018 may require a little more digging, but they’re still out there.

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