Volatility may be back

As a diversion from the investment publications, blogs, websites and books I devour regularly, I sometimes read a bit of science. One of my favourite science authors is Richard Dawkins, a well known evolutionary biologist. One reason I like reading Dawkins work is because I see parallels between investors adaptively changing strategies for successful investing in the stock market – and life’s tendency to adapt to environmental changes on earth. 

 It is my belief that many investors have been very slow to adapt to the long termed sideways market that replaced the 1982 – 1999 bull market. For example, I recently attended a 2-day seminar on “Effective Management Techniques” sponsored by the Canadian Securities Institute. Many of the very experienced retail Investment Advisors attending this seminar expressed concern over the lack of portfolio returns for clients in recent years. I was dismayed to hear some participants discuss, as though it was unavoidable, the fact that they had not made money for their clients over the past decade. They were victims of the sideways market, and unable to do anything about it, apparently.  

 Darwin once said, “It is not the strongest of the species that survives, nor the most intelligent that survives. it is the one that is most adaptable to change.”. I was under the impression that many of these distressed advisors have been purveyors of investment products and mutual funds. While these investment products worked well during the bull market, many have not performed well in recent years.  It is clear in my mind that many investors should change their strategies to a more active, cost effective investment methodology in order to adapt to the new investment environment. Investors must learn to read the markets, and trade accordingly.

 Speaking of adapting to change on the stock market, many investors are aware of the increased volatility that markets have been experiencing over the past number of years. Macquarie’s Chief Investment Officer Craig Bassinger and his colleagues recently conducted a study on volatility as measured by standard deviation (which measures the variability around the average of performance data). 

 Craig notes that there is positive volatility and negative volatility. To quote Craig, “Nobody minds if the TSX returned 10% more than the average!”  Enter downside deviation, also known as negative volatility. Craig’s study shows that the S&P 500 five year rolling downside deviation is at its highest level since the 1940s. While the TSX is not at its highest level of downside volatility, it is also clearly elevated. So the numbers support it:  we are investing in more volatile times.

 Given the new reality of higher volatility, particularly the negative kind, we might want to keep an eye on the VIX. The VIX is an indicator that follows expected volatility through CBOE options trading. While the recent rally on North American stock markets drove the VIX to 12 month lows last month, there is some indication that this volatility indicator may be forming a base. The recent rally off of its bottom seems to suggest that some type of Phase 1 bottom pattern may be in the works – such as a “head and shoulder bottom” or a “rounded bottom” (for more info on market phases, refer to my book, Sideways). Its too early to tell if a base will complete itself at this point, but it bears watching. A move by the VIX above 20 may be an indication of the completion of a bottom formation. Such a breakout – per the chart above – may be an indication that volatility is returning to the markets, and hedging strategies should be utilized. Make sure you adapt to the realities of a changing market if and when such patterns emerge. It may be paramount to your survival as a stock market investor.