What Volatility Means For Your Stocks
Today, I would like to introduce to you a valuable indicator that comes from the options world and what it is telling us about the future for small cap stocks.
More than likely, you've heard its name on CNBC, Bloomberg or read about it in the Wall Street Journal or Financial Times. The indicator is the well-known and popular VIX.
I want you to know up front that you don't have to know the first thing about options in order to use the VIX to understand risk in the market.
The VIX can be viewed as the "investor fear gauge" index. It measures the volatility and fear in the market by tracking the implied volatility of at-the-money put and call options for a 30-day period in the S&P 500.
When stocks go down, option volatility (VIX) increases as more options traders buy puts to either protect their stock portfolio, as an alternative to shorting, or to speculate.
This is exactly what has been happening over the last few weeks.
The Chicago Board Options Exchange Market Volatility Index (VIX) has pushed higher as the market has become more fearful about the current state of the market.
Towards the end of May the VIX hit a low of 14.6 before spiking to 18.49 on Monday. The 27.8 percent spike is noteworthy but far from out of the ordinary.
So... what does it mean?
· Typically, a VIX below 20 means the market is complacent and investors are not concerned about the current outlook of the market.
· A VIX reading greater than 30 generally means that investors have become more fearful about the current state of the market and the increase in volatility is a result of the increase in investor uncertainty.
The further the VIX increases, the more panic there is in the market. The further the VIX decreases, the more complacency there is in the market. As a measure of complacency and panic, the VIX is often used a contrarian indicator.
***So how can we use the VIX with small cap stocks?
According to Credit Suisse, "since the mid-1990s and in recent years, staples (drug and grocery stores, along with foods in recent years), health care (most groups exclude facilities), and utilities (all groups excluding telecom) have tended to outperform when the VIX is rising.
Elsewhere, trends seem to be shifting. Consumer discretionary (most groups excluding education) has mostly tended to underperform when the VIX rises, but the first-half 2010 spike in the VIX was an exception.
Financials have historically lagged when the VIX has moved up, but in recent years this relationship has broken down, mostly because Banks no longer lag when the VIX moves up and now, like Insurance groups, tend to lead when the VIX rises.
But perhaps most interesting for you and me is their findings about what the VIX means for small caps right now
"Relative performance against the Russell 2000 for materials and tech (especially semiconductors and semiconductor equipment), producer durables, and energy (especially oil and gas equipment and services) has been more inversely correlated with the VIX in recent years, suggesting vulnerability in the global growth/momentum trades if the VIX continues to move up."
I basically stated the same sentiment in my article "Have Small Caps Peaked?" back in April.
***I agree with the analysts over at Credit Suisse, with small caps trading at rich valuations, now isn't the time to be buying an index fund. Instead, times like this point to the importance of stock picking and finding the individual small cap stocks that are hidden gems.
So with a pullback expected for small caps, now is the opportune time to carefully analyze individual small cap stocks in search of the best opportunities.
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