I hope this week’s email finds you in good form and enjoying the continued rally in the equity markets. The rally since Christmas has been as impressive as it was unexpected (at least to those who don’t read the Global Investment Letter). This brings me to the topic for this week.
One of the pleasures of communicating with the Global Investment Letter community, apart from sharing investment ideas, is the opportunity to share some of the techniques I’ve developed over the years to guide me in my analysis. This week I would like to focus on the importance of monitoring the volatility levels of markets.
The chart above depicts the CBOE Volatility Index (VIX), which is a calculation of expected market volatility over the next 30 days. It is derived from computing the implied volatility from traded options. It has historically been a useful gauge of fear or complacency on the part of investors. Low levels reflect complacency (usually the result of a rising market), while spikes in the VIX represent investor fears (typically the result of market corrections).
As illustrated in the chart above, the VIX is currently trading at levels last seen before the start of the correction last fall, which suggests a return of investor complacency. Complacency is dangerous in any aspect of life, not least of which in the world of investments.
The chart suggests caution as it raises the probability that we may see a market pullback. A pullback would not be surprising given the ongoing strength since the Holidays. The odds increase further as we leave the seasonally strong November-April period. In addition, my work suggests that volatility measures have contracted in many markets, across asset classes, which suggests that we may see a return of widespread volatility. I have found that it is the nature of volatility to be mean-reverting; periods of low volatility are followed by spikes in volatility and vice versa.
This level of complacency is not a signal itself, but does suggest caution in that the odds of a change of trend are increasing. The chart demonstrates the value in taking a contrary view from the extremes of emotion portrayed above.
I hope this discussion of volatility has been of interest. I believe it is a concept that is worth bearing in mind when looking at any market.
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On behalf of your editor and the rest of the Global Investment Letter team,
Editor & Publisher