The most recent gain for the S&P 500 from the June low of 1282.55 to the September high of 1418.16, if viewed from a “the market is a discounting mechanism” perspective have occurred with no change in interest rates and arguably no change in fundamentals; by elimination therefore, this move of a little over 10.5% or essentially all of this year’s gains are the result of a reduction in the risk premium for the market.
This is confirmed by the drop in the 20-day realized volatility statistic for the S&P 500 which has fallen from 26.12% in June to Friday’s 6.10%, the lowest registered since January of 2011. This is above the lowest reading since 2000 of 4.45% but well below the average for the period of 18.11% and high of 83.03% set during the height of the fiscal crisis and the low point for the equity market.
Risk expectations as measured by the popular VIX have likewise fallen from 26.12 in June to a 5-year low of 13.45 set September 17th, Although this past week it has risen back above 17.
So looking over our shoulders, the market has rewarded “Risk-On” or risky assets as volatility has declined.
Now its important to note that this does not mean that the market is poised to go down, as volatility can remain low for extended periods of time. What it does mean is that for equity prices to continue to appreciate will require a further drop in interest rates, which is unlikely or a meaningful improvement in fundamentals as the price of risk or the risk discount is unlikely to fall much further.
So what is an investor to do?
First understand how we got here — the price of risk went down! So second, evaluate what an increase in volatility would do to your portfolio. Chances are it is time to “Risk-Off” to reestablish a balance. The steps to accomplish that are:
- Reduce leverage or raise cash. The purest way to reduce risk.
- Lower volatility and/or beta.
- Finally, if for tax reasons or other considerations selling securities is not ideal, portfolio volatility can be reduced with the addition of a volatility asset in the form of VIX futures, VIX mini futures, or even volatility ETN’s understanding that if volatility does not rise, the volatility asset will decline in price. But the trade-off is volatility has a lot more room above than below, so even a very modest allocation is likely sufficient to buffer any increase in volatility moving forward.
data sources: CFE, Trade-Alert LLC, Yahoo Finance and Differential Research LLC
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