VIX -1.80% . In its simplest form, the model calls for going to cash whenever the VIX rises above its median level of just shy of 20, and staying there until the VIX drops back below.
A buy signal could be close at hand, however: The VIX is now back to the low 20s — and could easily drop below its long-term median in the next week or two.
It was late last July when the VIX rose above its long-term median. The Dow Jones Industrial Average DJIA +0.56% was then trading around 12,500. The VIX has remained well above that median ever since, having skyrocketed to 48 in mid August. (Read my Aug. 1 column on using the VIX as a market timing indicator. )
Throughout this period of above-median VIX levels, the Dow has traded below where it stood in late July. This means that an investor who followed this simple approach has given up nothing in return for sleeping like a baby during one of the most turbulent periods in U.S. market history.
Usually, of course, we have to pay an insurance premium in order to reduce volatility and risk. In this case, however, it has been just the reverse — sort of like having your insurance company pay you to take out a policy with them.
Not bad.
Believe it or not, furthermore, this recent experience is not a fluke. The stock market’s average return over the last couple of decades has been higher following below-median VIX levels than above-median levels. This surprising result held regardless of whether these returns were measured over the following day, week, or month.
These results will surprise many because we have been conditioned to think of the VIX in contrarian terms. The CBOE is a co-conspirator in this conditioning, since the exchange refers to the VIX as an investor fear index. Contrarians therefore expect the market to turn in higher returns following higher VIX readings than lower ones — just the opposite of what has actually happened.
To be precise, however, the VIX measures expected volatility rather than fear. And there is no theoretical reason to expect volatility to manifest itself exclusively on the upside or the down. On average over time, therefore, the market should show relatively little overall trend when the VIX is high.
The reason that this knowledge is of use to market timers: Periods of high volatility tend to be clustered together — an insight that traces to research conducted by Robert Engle III, a finance professor at New York University who received the Nobel Prize in economics in 2003 for his work along these lines. To the extent the future is like the past, therefore, an investor who goes to cash whenever the VIX spikes upwards will end up forfeiting little return.
Another reason this simple use of the VIX hasn’t caught on, besides investor misconception about what the VIX measures: The approach requires investors to sit on their hands for long periods of time. And that’s hard to do, especially following the explosive up-days that are quite likely to occur whenever the VIX is high.
In the current situation, of course, a follower of this approach has been out of the market for over five months. That’s a lifetime to traders addicted to day trading and other high-frequency models.
In the end, this simple model’s success challenges us with the following question: Are we in the market every day to maximize long-term returns, or are we feeding an addiction to excitement?
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Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980.
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