“ Choose an average VIX level that matches your target stock allocation. ”
The US stock market is struggling, but you might still want to give the bulls the benefit of the doubt.
That’s the conclusion I draw from a groundbreaking study into the use of volatility as an indicator of market timing. It’s called “Volatility-Managed Portfolios” and was conducted by finance professors Alan Moreira of the University of Rochester and Tyler Muir of UCLA. The research challenged the conventional view of volatility, finding that you can beat the market over the long term by having higher equity exposure when market volatility is lower.
I have previously written about Moreira and Muir’s research. I’m focusing on it now because the CBOE Volatility Index VIX VX00,
In mid-September, it fell to a low not seen since early 2020. It fell so low that some financial advisors considered it “mysterious.” Since then, the VIX has risen, although it is still 20% below its historical average.
It seems difficult to put a bullish spin on the low the VIX hit in mid-September, given that the last time it was this low was right before the stock market’s waterfall decline – in which the S&P 500 SPX fell in 33 days 34% fell. But no market timing system is perfect. Even taking this colossal misstep into account, the professors’ approach won out over a buy-and-hold strategy in the long run.
That does not guarantee that it will continue to work, as it is always possible that “this time is different” (to quote the four words considered the most dangerous on Wall Street). But in the absence of a fundamental change in the markets that makes the professors’ research no longer useful, their approach deserves serious consideration. They showed that you can improve your long-term risk-adjusted performance by gradually increasing your stock exposure as the VIX falls, and vice versa.
Volatility advantage
While the volatility-based market timing strategy that the professors outline in their research may be more complicated than some of you would like to follow yourself, they have given me a more basic version that should be easy to implement.
The core idea is to choose an average VIX level that matches your target stock allocation. To calculate your stock exposure level in a given month, multiply your target by the ratio of your VIX baseline to the closing VIX level of the immediately preceding month.
To illustrate, let’s assume your target stock allocation is 60%, and the average VIX level corresponding to that target is the historical median of 17.79. Since the VIX was 13.57 at the end of August, your stock allocation for September would be 78.7% (60% times the ratio of 17.79/13.57). And let’s say the VIX closes September at its level on September 22, then your allocation for September would still be above your target level, at 65.6%.
The professors’ approach works because the stock market performs better on average over the long term, relative to the volatility of returns, when volatility is low. You can see this in the table below, which breaks down all trading sessions since 1990 (when the VIX was created) into quartiles. Note that the highest return-volatility ratio is for the quartile of days when the VIX was lowest.
Average Wilshire 5000 return over the following month | Standard deviation of subsequent months’ returns | Return/volatility ratio | |
25% of days with the lowest average VIX level |
0.81% |
2.50% |
0.33 |
Next 25% |
0.65% |
3.56% |
0.18 |
Next 25% |
0.66% |
4.79% |
0.14 |
25% of days with the highest average VIX level |
1.55% |
6.64% |
0.23 |
The table also shows that the conventional wisdom about VIX is not wrong: raw stock market performance is indeed better on average in the aftermath of days when the VIX is particularly high. But what that conventional wisdom obscures is that those returns are extremely volatile. The standard deviation of returns over the following months after the top quartile of trading sessions is almost three times larger than that for the bottom quartile, even though the average return in the top quartile is less than twice as high.
So don’t give up on the bull market just because the VIX recently reached such low levels. If the future looks like the past, it’s a good bet that the US market will deliver above-average risk-adjusted performance in the coming months.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be reviewed. He can be reached at mark@hulbertratings.com
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