The Investment U E-Letter: Issue # 456
Friday, July 29, 2005

Stock Market Volatility: At 20-Year Lows… What to Do? Check the Volatility Index
by Dr. Steve Sjuggerud, Chairman, Investment U

Volatility in the stock market is at 20-year lows

It feels like a calm before the storm to me and it makes me apprehensive.  There is no doubt that the rains will return someday.

Rain in itself is actually a good thing, of course.  It’s the unpredictable “monster storms” that wreak havoc.

Right now, the stock market is showing anything but volatility. The market is “as placid as a produce market” (to borrow a phrase from John Kenneth Galbraith).  No, scratch that it’s even sleepier.

So what does a sleepy stock market mean for us as investors?  Do we buy stocks or sell them? 

I’ll try to answer that today. 

To save you time, the short answer for what to do is: Go about your regular business.  Yes, rains will come.  But 100 years of history shows that the stock market can do just fine as volatility increases.  When volatility is high, it’s time to buy, as I’ll show.  But when volatility is low (like it is now), it’s NOT time to go

“When the VIX Is High, It’s Time to Buy”

The Volatility Index (VIX) is the most popular measure of stock market volatility.  Its data history goes back to 1986.  As the chart below shows, right now, we’re close to all-time lows in volatility.

As you can see from the chart, volatility soared during the Crash of 1987.  It jumped when Iraq invaded Kuwait a few years later.  It jumped during the Asian crisis in late 1997, and after the crash of the LTCM hedge fund in 1988.  It jumped up after September 11th, 2001.  You get the idea - volatility in the stock market soars after major uncertainty appears.

For investors, the right rule has been “when the VIX is high, it’s time to buy.”  Throughout the history of the VIX, when volatility jumps, and then starts to subside, stocks then jump.  This makes sense you make the most money in stocks when you’re willing to step up and when others won’t. 

By buying when the Volatility Index (the VIX) is high, you’re gambling that, whatever the horrible uncertainty is that’s hit the market, it will pass.  And once that uncertainty is lifted, stocks will rise.  Whether you agree with the logic or not, when you test out the strategy, it’s been really profitable over the life of the VIX, going back to 1986.

So if the rule is, “when the VIX is high it’s time to buy,” you might think “when the VIX is low, its time to go.”  But that hasn’t been true.  Of course, we have to consider that the entire history of the Volatility Index (1986 to present) has been during the greatest bull market in stocks in history (1982 to present).  It’s simply not enough history to judge.  So, let’s go farther back

100 Years of Stock Market Volatility: A Quick Look

My friend Jason Goepfort of www.sentimentrader.com did an interesting study recently he created a “faux-VIX.”  He devised a way to mimic the VIX going back to 1900.

A reading of 11 on the VIX roughly means that traders don’t expect the stock market to move more than 11% in either direction in the next 12 months.  While readings in this range have been quite rare for the last 20 years, Jason’s results over 100 years of study were surprising he found that his 100-year VIX was lower than current levels over one-third of the time.  In plain English

Even though volatility in stocks seems extremely low right now, according to Jason Goepfort, stock market volatility is not low today by historical standards (over the last century).

Jason says the stock market goes from extended periods of high volatility to extended periods of low volatility.  He says the average streak for each is about five years. 

We saw an extreme period of volatility from 1998 to 2003, so Jason says “it would conform to historical standards if we went another two years or more before seeing a large (and sustained) jump in volatility.”

A Great Buy Signal - The First Volatility Spike

Okay, enough of the number crunching.  The conclusion is simple: When the VIX is high, it’s time to buy.  However, when the VIX is low, well, ignore it.  Yep.  That’s right.

As Jason says about the current streak of low volatility: 

“Once this streak ends (by historical volatility rising above 20), will that be the signal to sell?  Not according to history  60 days after any streak ended that had lasted at least one year, the Dow was positive 9 out of 13 times with an average return of 7.4%.  Six months later, it was higher 12/13 times with a return of 10.3%.”

In sum, instead of running for cover at the first spike in volatility, Jason says actually “buying the first large spike in volatility has paid off time and time again.”

I was concerned about this sleepy time in the stock market.  It feels like a calm before a storm to me.  And it may be.  However, history tells us that we’ve had extended periods of low volatility before, and that rising volatility in itself (like a rain shower) are nothing to worry about.  It can be a part of a rising stock market.

How to Handle the Next “Monster Storm”

Of course, an unpredictable monster storm could wreak havoc, driving stock prices down and driving the VIX up to crazy levels again.  Everyone will be scared. 

If this happens, of course, you’ll remember the phrase “when the VIX is high, it’s time to buy” and you’ll buy when others are selling.  Right?

The markets are calm and freak storms are unpredictable.  So the low volatility in the stock market these days, looked at by itself, is nothing to worry about.

Good investing,

Steve

Today’s Investment U Crib Sheet

• To track the Volatility Index on Yahoo! Finance, use the symbol ^VIX.
• Jason Goepfort likes to do number crunching like I do.  You might like what he does Check out his work at www.sentimentrader.com.

Related Articles:

• Financial Market Volatility What Should Investors Do In a Market Downturn?
• The VIX Indicator: Know When To Buy and Sell
• Investor Sentiment IndicatorsOminous Optimism

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