Does Low Volatility Put Your Portfolio At Risk?

by Alexander Green, Investment U Chief Investment Strategist
Friday, January 27, 2012: Issue #1695

The stock market gyrated so wildly in 2011 that many investors finally threw in the towel.

How else can we read the massive equity fund redemptions that occurred in the second half of last year?

But, apparently, the market has taken its anti-anxiety medication. After last year’s gut-wrenching swings, U.S. stocks have been surprisingly tranquil. For 13 straight days, the Dow has moved up or down less than 100 points.

This is good news for bullish traders and bad news for those who have been making money trading the VIX. Let me explain…

The VIX is the ticker symbol for the CBOE Market Volatility Index, a popular measure of volatility in S&P 500 index options. According to The Wall Street Journal, this so-called “fear gauge” has fallen 20% to levels unseen in six months.

Why? One reason is that the U.S. economy appears to be getting back on its feet. Despite all the pessimism in the Eurozone, U.S. corporations are busy reporting yet another quarter of all-time record profits. (Just how long will mom-and-pop investors ignore this salient point?)

The Dow is up almost 500 points for the month. Fund companies report that money is flowing back into equities again. Yet the calm makes some investors nervous. I hear many analysts crying out that the market is about to plunge again.

Deluded, Ignorant, or Both

Let’s start with the straightforward declaration that anyone who claims to know “what the market is going to do next” is, by definition, someone who is ignorant, deluded, or both. The market will rise or fall next week or next month based on next week’s or next month’s news. Yesterday’s news has already been discounted. (As Legg Mason’s Bill Miller likes to say, “If it’s in the papers, in the price.)

Moreover, there’s no historical evidence to show that a market pause generally precedes a correction. And the data go back pretty far.

For example, market analyst Mark Hulbert has loaded the Dow’s daily returns – all the way back to its creation in 1896 – into his statistical software. For each trade date since, he calculated the Dow’s trailing volatility and then looked to see if the stock market performed any different following periods of low volatility than it did at all other times.

The short answer? Nope. He came up empty. Perhaps that’s the reason for the old Wall Street saw: “Never sell a dull market short.”

There are two things to conclude here:

The hair-raising volatility that made trading (going long) the VIX like taking a tootsie roll from a toddler is over, at least for now…
The other important takeaway is that traders and investors have no historical reason to believe that the recent pause portends a market downturn ahead.

Sure, a spike in oil prices, a hedge fund blow-up or a nasty surprise from across the pond could change that in a nanosecond. But bolts out of the blue are just one of the many short-term hazards of trading and investing.

For now, the market is taking a breather. But that doesn’t mean it isn’t about to get a second wind.

Good Investing,