Now is a good time for risk-averse investors to consider getting back into stocks.
That’s because the CBOE Volatility Index
VIX,
recently dropped to its lowest level in more than three years. This suggests that U.S. stock market volatility is likely to remain low for at least a few more months.
Yet this isn’t how many on Wall Street view the VIX’s low. They instead interpret the VIX in a contrarian way, believing its low level indicates dangerous complacency — the calm before the storm. But stock market history does not support this interpretation: Periods of low volatility are more likely than not to be followed by additional periods of calm, and vice versa.
To show this, I segregated all months since 1990 into two equal-sized groups according to their average VIX level. I then calculated the average and standard deviation of the S&P 500’s
SPX,
returns in the subsequent month. What I found is summarized in the table below:
| Average S&P 500 return in the subsequent month | Standard deviation of S&P 500 returns in the subsequent month | |
| The 50% of months with the lowest average VIX level | 0.93% | 2.68% |
| The 25% of months with the highest average VIX level | 0.87% | 5.44% |
“ You can equal the market’s return over the long term, with lower risk, by increasing your equity exposure when the VIX is low. ”
The investment implication of these results is that you can equal the market’s return over the long term, with lower risk, by increasing your equity exposure when the VIX is low and reducing it when it is high.
A lower-risk strategy increases the likelihood that investors will actually stick with it through thick and thin. The stock market’s significant volatility is one of the big reasons why investors periodically throw in the towel — almost always to their long-term detriment.
Volatility-managed portfolios
These implications were spelled out in greater detail in a 2019 academic study in the Journal of Financial Economics. Entitled “Volatility-Managed Portfolios,” it was conducted by finance professors Alan Moreira of the University of Rochester and Tyler Muir of UCLA.
They have provided me with simple rules for putting these implications into practice:
- Pick a target or default equity allocation. For example, if you’re following the traditional conservative allocation of 60% stocks and 40% bonds, your target or default equity allocation would be 60%.
- Determine a middle-of-the-road VIX level that will correspond with your target equity allocation. For this illustration, I assume this baseline is equal to the VIX’s median level since 1990, which is 17.77.
- To determine your precise equity exposure level for each month, multiply your target allocation by the ratio of your VIX baseline to the closing VIX level of the immediately preceding month.
For example, if the VIX were to end June where it stood as of June 12, your equity allocation for July would be 71% (60% times 17.77 divided by 15.01). At its low point last year, in contrast, your equity exposure would have been 35%.
A portfolio that followed these rules in the past would have significantly beaten a 60/40 portfolio on a risk-adjusted basis. Assuming the equity portfolio is invested in the S&P 500 and the bond portion in 90-day U.S. Treasury bills, the volatility-managed portfolio since 2000 would have produced a 4.8% annualized return, equal to that of the 60/40 portfolio, while incurring 17% less volatility.
That’s a winning combination.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com
Plus: It’s a ‘bull market’ for stocks. Here’s what that means.
Also read: Investors increasingly expect U.S. stock-market rally to continue as bears finally surrender
This post was originally published on Market Watch
