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MarketWatch


VOLATILITY KNOCKS: HERE'S HOW YOU CAN USE THE VIX TO BEAT THE STOCK MARKET

Provided by Dow Jones
Sep 30, 2023 6:18pm

By Mark Hulbert

Stocks perform better when volatility is low

Pick a middle-of-the-road VIX level that corresponds to your target equity
allocation.

The U.S. stock market is struggling, but you may still want to give the bulls
the benefit of the doubt.

That's the conclusion I draw from a landmark study into using volatility as a
market-timing indicator. Entitled "Volatility-Managed Portfolios," it was
conducted by finance professors Alan Moreira of the University of Rochester and
Tyler Muir of UCLA. The study challenged conventional wisdom's 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've written before about Moreira's and Muir's research. I'm focusing on it now
because the CBOE Volatility Index VIX (VX00) in mid-September fell to lows not
seen since early 2020. It dropped so low that some financial advisers deemed it
"mysterious." Since then the VIX has jumped, though it remains 20% below its
historical average.

It seems difficult to put a bullish spin on the low the VIX established in
mid-September, given that the last time it was as low was immediately before the
stock market's waterfall decline -- in which the S&P 500 SPX shed 34% over 33
days. But no market-timing system is perfect. Even after taking that huge
misstep into account, the professors' approach has beaten a buy-and-hold
strategy over the long term.

That doesn't guarantee that it will continue to work, since it's always possible
that "this time is different" (to quote the four words that are considered the
most dangerous on Wall Street). But absent some fundamental change in the
markets that render the professors' research no longer useful, their approach
deserves serious consideration. They showed that you can boost your
risk-adjusted performance over the long term by gradually increasing your equity
exposure as the VIX falls, and vice versa.

Volatility advantage

Though the volatility-based market timing strategy the professors outline in
their study is perhaps more complicated than some of you would be willing to
follow on your own, they have provided me with a more elementary version that
would be easy to implement.

The core idea is to pick a middle-of-the-road VIX level that corresponds to your
target equity allocation. To calculate your equity exposure level in any 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 equity allocation is 60%, and the
middle-of-the-road VIX level that corresponds to that target is the historical
median of 17.79. Given that the VIX at the end of August was 13.57, your equity
allocation for September would be 78.7% (60% times the ratio of 17.79/13.57).
And let's say the VIX finishes September at its level on Sept. 22, your
allocation for September would be still above your target level, at 65.6%.

The professors' approach works because, over the long term, the stock market on
average performs better, relative to the volatility of its returns, when
volatility is low. You can see this in the table below, which segregates all
trading sessions since 1990 (when the VIX was created) into quartiles. Notice
that the highest return-to-volatility ratio is for the quartile of days when the
VIX was lowest.


                                               Average Wilshire 5000 return over subsequent month  Standard Deviation of subsequent-month returns  Ratio of return/volatility 
   25% of days with 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 highest average VIX level  1.55%                                               6.64%                                           0.23 

The table also shows that the conventional wisdom about VIX isn't wrong: The
stock market's raw performance is indeed better, on average, in the wake of days
in which the VIX is particularly high. But what that conventional wisdom glosses
over is that those returns are particularly volatile. The standard deviation of
subsequent-month returns following the top quartile of trading sessions is
nearly three times greater than for the bottom quartile, even while the top
quartile's average return is less than twice as much.

So don't give up on the bull market just because the VIX recently hit such low
levels. If the future is like the past, it's a good bet that the U.S. market
will produce above-average risk-adjusted performance in coming months.

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

More: The Fed got inflation wrong. That's why a 2024 downturn looms, says
professor who pioneered popular recession predictor.

Also read: The U.S. could be in a recession and we just don't know it yet

-Mark Hulbert

This content was created by MarketWatch, which is operated by Dow Jones & Co.
MarketWatch is published independently from Dow Jones Newswires and The Wall
Street Journal.


 

(END) Dow Jones Newswires

09-30-23 1218ET

Copyright (c) 2023 Dow Jones & Company, Inc.
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