Precisely predicting every stock market crash to the very day is impossible for humans. Period. You can have luck once or twice, but not build a career on it. But what if you could look at some early indicators to massively improve your odds and know when to take the foot of the gas? You could timely hedge your portfolio to avoid bigger damage. There is even a stock that profits from market turmoil.
Who doesn’t know (and isn’t tired of) the ever-warning crash gurus calling for the next major crash in the stock markets? There are many of them. For Germany, I immediately can think of at least a handful. In the US it is not so different. Everywhere there is a representative of this species patting himself on the back for having seen (at least) a temporary downturn coming in the past.
According to them, you should be scared that the next 1929, 1987, 2000, 2008 or even 2020 style meltdown should be imminent. Is it a good strategy to wait for the next such crash, because some of the crash prophets have track records in predictions?
The fear mongering in between is kept out, however.
It has seldom paid out to listen to crash gurus and to act based on their predictions. More often than not did you lose money. Not necessarily literally, but you missed on gains waiting for the crash that never came (or took way longer to materialize).
To quote Peter Lynch – one of the best investors:
Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.https://www.azquotes.com/author/9159-Peter_Lynch
The crash gurus sound like broken records, coming out every once in a while.
If you repeat yourself often enough, there will necessarily come a time when you will be right. Exactly the same way a broken clock shows the right time twice a day.
Photo by Kjartan Einarsson on Unsplash
But the good news and the main topic of this article is that there is an indicator which acts as a relatively reliable barometer. It won’t give you any precise buy or sell recommendations (just like I don’t do either). Also, it there won’t always come a correction, immediately. This often takes longer than you think.
Rather, it gives you a broader feeling for the mood in the market.
Most of the time, it is best to do nothing, though.
However, when extremes are reached, it is often wise to start thinking about doing the opposite. Not running with the herd, but standing against them is the way to make profits (or avoiding being sucked in).
Today, you will learn what tool I am talking about, how to read it and how it could complement your portfolio strategy.
As a bonus, I am giving away a full research report about a listed company that is profiting from turmoil in the markets – for free. The greater and faster the crash the more the company earns on its bottom line (and pays out in dividends). The price has come down substantially and makes the stock worth a look. Everyone who signs up for my free weekly newsletter will receive my case study – for free, no further obligations. No spam, no affiliates. Just click here.
Sounds too good to be true? After a longer intro, let’s dive in.
What you should know about volatility and how to measure it
Volatility in easy words – what you really need to know
What does the often heard “volatility” mean?
Volatility is a statistical figure of an underlying security (a stock, bond, option, etc.) that measures the dispersion of expected returns. It is often derived from the standard deviation or the variance of returns.
Who is interested in more details can read on here.
In easy words as promised: Volatility tells you something about the potential swings of an investment you are looking at. That means, there is an expectancy in the market for broader price movements. Thus, the possible outcomes are more difficult to predict. You have to be ready for wilder swings.
For example, so called Blue Chip stocks (the big players) like Johnson & Johnson (Ticker: JNJ, ISIN: US4781601046) or Apple (Ticker: AAPL, ISIN: US0378331005) tend to be very stable stocks that don’t move much in general. You won’t see these stocks swing up 10% on one day, followed by a 15% drop the next day – only maybe when fundamentally something changes dramatically which is currently not expected.
Not so for technology stocks and especially for companies with lower market capitalizations that do not meet expectations. Just look at some recent moves of Novavax (Ticker: NVAX, ISIN: US6700024010) or Coinbase (Ticker: COIN, ISIN: US19260Q1076) that have had many double-digit moves in a single day, frequently. 30% up or down is not uncommon.
Keep in mind that during the biggest one day crash in recorded history in October 1987 the Dow Jones lost 22.6% in a single day.
We are talking about really big moves here.
Both mentioned stocks above jump around more than that from time to time, depending on the news.
Volatility and risk – one and the same?
It is generally said that more volatile investments tend to be riskier.
I think of the last sentence as being absolutely irrelevant and even misleading. There certainly is a correlation between the measured volatility and the price movements. But it does not tell you anything about the underlying business.
And more importantly: It doesn’t prevent you from being caught on the wrong foot with negative surprises, as we will see, soon.
Assuming you are a fundamental investor like I am and you know what you are doing and what you are owning. There is not necessarily a higher risk with your investment. If you did your due diligence, you can rest assured most of the time. Commodity companies naturally are more volatile due to being depended on prices for resources That’s their business. When you are in an uptrend and found a good business that does not mean you have are very risky investment. It’s cyclical in this case, but not automatically risky per se.
Isn’t that a contradiction? Not necessarily, I give you two examples:
Low-vola companies like Walmart (Ticker: WMT, ISIN: US9311421039) or Intel (Ticker: INTC, ISIN: US4581401001) where thought of as being reliable blue chip companies with multi-hundred billion dollar market caps “one cannot do anything wrong with”.
WMT crashed on May 17 2022 when it massively lowered its guidance due to inflationary pressures. The biggest retailer of the world fell more than 10% on roughly 6x the average daily volume!
And Intel? It too had several drops of more than 10% due to not delivering on expectations and delaying plans of releasing their newer chip generations.
What you need to take home until here in short:
Higher volatility tends to mean more action (price movement) is expected. Keep that in mind. I stressed “expectancy” and “expected” twice already. Where big price movements tend to occur in high vola stocks, it is not necessarily set in stone the other way around: Low-vola doesn’t mean that there won’t be any large moves. It is just the current expectation. That is the key point we are approaching slowly for our possible portfolio implications.
How to measure volatility for the general market sentiment?
To hedge a portfolio, it practically doesn’t make any sense to hedge all your individual positions separately. Not only would it inflate (double) the amount of your portfolio positions (more to monitor). It costs more, especially when you have stocks with more implied volatility.
Just negatives, no positives in most cases. You want to bring calm into your portfolio, not hectic.
What you need to look at, instead, ist the general market sentiment. Is there fear or is there greed? If there is an extreme in the market, then it is time for you to start thinking about acting. That is the time when the odds shift in you favor, in case you understand the basics.
The most practical way to measure market sentient concerning volatility is to look at the expected vola of the S&P500 index that stands for the broader market (though in the not so distant past the Big Tech stocks had a very high weighting).
Just look at the “VIX-Index”.
You can find it
- here on a German page
- here as a sub discipline of the CNN Fear and Greed Index
- or here on Seeking Alpha.
The VIX swings up and down and tells you something about current market expectations concerning the breadth of the next moves.
Looking closely, you will see that overall the VIX index tends to swing in a broader range of 20 to the upper 30’s most of the time (red lines are mine to showcase this trading range better).
There are sometimes periods with values of under 20 and above 40. That are these extremes, I already referenced to:
- In 2009 and 2020 the VIX went completely nuts hitting above 80 for a short period – panic mode.
- Before the early 2018 correction the VIX went even under 10 (!) for a brief period, hence there was nearly no movement expected.
- Before the 2020 crash, the VIX sat under 20 for many months before spiking up
What you see besides that are two observations:
- when the VIX pumps up massively, it relatively quickly drops back down – the panic only lasts for a while
- however, the VIX can hover under 20 for several months – though this was a rather modern phenomenon
So, when is the right time to act and how?
All of that will be answered in the next section.
How to make use of volatility for your portfolio – three possible strategies
I have put together three ways for you to think about, research further and maybe consider implementing into your portfolio strategy.
But keep in mind, this is only thought of as being an inspiration for you. I don’t show any ready-to-go recipe. When odds are in your favor, you can lose money nonetheless. A higher probability is no guarantee! The VIX can stay in lower territory longer that you expect.
Let’s get through them one by one in brief.
Take the foot of the gas / press kick-down when the VIX hits extremes
This is the most defensive strategy. However, it can be very effective. I definitely don’t want to talk this move small.
You need to be patient, though. That is the main ingredient. Observe the VIX index for a while. When it declines into the lower 20’s or even below 20, then you can start selling some of your positions. If a correction occurs, it will have a smaller negative impact on your overall portfolio. Plus, you will have some powder dry to reenter the market when prices have become more attractive.
But as said already, that can take months! You shouldn’t lose your nerves in the meantime for selling too early.
Rarely does anybody hit the absolute lows and highs. Being roughly right is better than being precisely wrong in this case – as Charlie Munger said, inspired by John Maynard Keynes.
For example, say you sell 25% of your stocks. When the market tanked 30%, your personal drawdown would be – ceteris paribus – just 22.5%. A delta of 7.5%. Not the biggest hit at first glance. But that equals to an outperformance by about the same amount as the average annual return of the broader stock market.
Plus, don’t forget that you would have 25% cash on the side ready to deploy in this scenario. This way you would have more steam on the way back up, because the 25% that didn’t fall with the market could generate performance for you (instead of having to make up the losses first, were you fully invested).
That’s the theory.
This is easier said than done, because it depends on several factors.
Selling winners in most jurisdictions causes you to pay taxes on your gains. The other question ist whether you will be able to buy back into your stocks cheaper. It cannot be ruled out that some of your sold stocks don’t come back enough or either. You could lose by not being in the market (see the Peter Lynch quote at the beginning).
Hence, you have to look at your individual circumstances and maybe talk to your tax accountant about tax implications.
It is only one way I wanted to present to you about rethinking your portfolio alignment. For some, it will be an attractive way with relatively low effort to set up a more defensive approach with peace of mind, in case you don’t get emotional in between.
The same applies the other way around:
Of course, during a stock market crash when the VIX goes through the roof (i.e in most cases above 35), it is often a good time to come back and buy. Maybe not to go all in immediately. But to start buying back in.
The higher the VIX shoots, the better your chances that Mr. Market went crazy. Panic selling by others is time to buy for you for the long run!
But of course, prices can drop further. You have to be able to stomach that. Be patient and play around the broader picture.
Handling the VIX directly via Options
This is only something for experienced investors. Also, the matter is shortened here to make only the key points and overall thoughts clear. Please educate yourself extensively about this topic (especially pricing of options and potential losses), if you should find it interesting. In contrast to the strategy before, here, you can suffer real losses! And, you have the time component against you, because options expire.
This is one way I like to use to hedge my portfolio. It does not have to be hedged necessarily 100%. If you can dampen your losses, it is already a successful outcome. Like in the strategy approach above, if successful, you will have cash ready to invest into the fallen market.
Because it is mandatory to understand, I am writing the following here again:
- When the market (S&P500) goes up, the VIX goes down. Sometimes in bigger steps, but often in moderate moves.
- When the market (S&P500) goes down, the VIX goes up. But, it often does so rather dramatically. The higher the uncertainty or even panic, the bigger the moves will be in general.
You see, there is an opposite (or inverse) correlation.
- Market up = VIX down.
- Market down = VIX up.
In theory, should the stock market jump massively, the VIX could jump, too, because of a big move and uncertainty. But in practice, that never happens. A big jump in the market is a sign of relief (even for now), hence the VIX comes down. The above applies.
For your strategy this means that it could make sense to buy call options on the VIX when you expect the market to fall (i.e. volatility to rise). That is because of currently low volatility and thus low movements expected. Remember the inverse correlation!
But options have only a limited time before they expire. Think of a timely capped insurance. You pay a premium for being temporarily safe. The higher the VIX stands, the costlier your insurance. Thus, you better wait until the VIX is as low as possible. For example, it would be nonsense to hedge a portfolio if the VIX sits around 30. You can be a lucky winner, but the odds are not in your favor.
The lower the VIX, the better your chances.
But there is no guarantee!
And you have to be ready to act quickly when the VIX jumps. As explained, it does not stay for very long on elevated levels. This strategy needs you to be more involved than you maybe want to be in your portfolio management. That is not for everyone.
A listed company which profits directly from massive market turbulences – yes, there is one!
The third case I wanted to introduce to you is special.
It is not an overall strategy per se, but an anti-cyclical stock you could have in your portfolio, should you expect the markets to fall massively.
In short, the company is the leading market maker for ETFs and Crypto transactions in Europe. They are also expanding in other securities and geographies. When there is panic in the markets, the trading volume usually goes up and spreads (the difference between bid and ask prices) widen.
These are the times when this particular company really cashes in. But also in normal times, it earns good profits on strong margins, but less so than during crashes.
Anyway, it distributes at least 50% of its income via dividends. After a panic, the payout can be a double digit dividend yield (already happened).
The good news, we have a solid proof that this company handles its business well: During the 2020 meltdown the stock climbed more than 50% (!) when everything else went into free-fall. Had you bought it before the 2020 crash, you would have had a stock appreciation of 50% plus a dividend of around 20% some months later on your initial investment (in case you bought around the low).
Although 2022 should have been a very good year for this stock, the price came down by more than a third from its peak. It currently sits again where it was before the 2020 crash. A déjà vu?
Compared to the current price, it has paid out more than a third in dividends since the start of 2020. A solid return, I think.
The price movement hasn’t been like two years ago, so far. This is because 2022 is not directly comparable to the crash of 2020. In my study, I explain why.
In my free research report, I introduce you to this company and explain all the relevant background information. You will learn, how this company earns money and why it earns disproportionately much more during stock market turmoil than in calmer bull markets.
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Volatility is a topic worth to deal with extensively. Many “value investors” or “longterm investors” will deny that, though. You should at least try to understand it and then see, if it is for you.
Once understood, it offers you several tools for your investment box to apply before the markets turn sour.
Of course there is never a guarantee – such a thing simply never exists in the investment world. It is always about opportunities, optionalities, odds and probabilities.
The higher the odds in your favor, the more you should consider it.