After gaining over 6% since the low on Christmas Eve, the S&P 500 declined -2.45% today. We can expect a wider range of prices in a volatility expansion after a -20% decline.
I say it’s a volatility expansion because implied volatility is relatively elevated at 25.45, implying a 25% range of prices is implied by options prices on the S&P 500 stocks.
Looking over its full history, we’ve seen the VIX trend higher, but it’s relatively elevated. Its long-term average is about 20. But, for mean reversing indicators like the VIX, the average doesn’t mean much since it doesn’t stay there.
Another way I define a volatility expansion is realized volatility. The VIX is expected volatility implied by options prices, realized volatility is actual historical volatility. In the chart below I added an average true range over the past 14 days above the S&P 500 stock index price trend. We can see how volatility expanded as the price trend fell. Prices tend to spread out in a wider range in a downtrend. We can see this in the chart. There was a regime change from a low volatility uptrend to a downtrend with volatility expansion.
The CBOE Put Call Ratios spiked up today. Zooming in to a 30 day period, we see the Index Put Call Ratio is about where it was at the lows in December. I believe the Index Put Call Ratio is a better indication of extremes in fear of lower prices because index options are mostly traded by professionals and used for hedging. The Equity Put Call Ratio is options on individual stocks and more non-professionals and tends to be more speculative. I explained it in Investor Sentiment into the New Year 2019.
To get a longer view below is the past five years of the Put Call Ratios. They’ve been higher in 2015, but are clearly at elevated levels. It indicates the put volume on index options is 155% more than call volume, which suggests hedging or speculative bets the index will decline.
Prices decline until the selling pressure is exhausted. Selling pressure is exhausted after those who want to sell have sold, which pushes prices down to a low enough point to attract buyers. To get an indication of when prices have trended down far enough to exhaust sellers and attract buyers, I look at the price trend itself as well as extremes investor sentiment and breadth. Below is the percent of stocks in the S&P 500 below their 200 day moving average. The percent of stocks above their 200 day moving average reversed back down… only 14% are in a positive uptrend. There are currently 505 stocks in the S&P 500. Of the 18 that are above their 50 day moving average, two are because they are being bought out Celgene CELG and Redhat RHT. Some of the others are kind of recession stocks like auto parts, discount store, and a gold stock: AZO ORLY DLTR NEM.
The percent of S&P 500 stocks above their 50 day moving average reverses back down… only 3% are in an uptrend…
The stock market is approaching oversold levels again but may get more oversold before reversing back up.
One advantage of falling stock prices is as price falls, the dividend yield rises from that new price. This is not a recommendation to buy or sell any security, but below is the price trend and dividend yield the Global X SuperDividend® ETF (SDIV). It invests in 100 of the highest dividend yielding equity securities in the world. We can observe as the price trends down, the dividend yield trends up. That is, if we buy high yielding assets at lower prices, the dividend payment is higher from that starting point assuming the companies keep paying their dividends. Below we can see how this ETF yield has increased to 9% as its price has fallen -35% off its high.
Like any investment, it isn’t risk-free. Investing always involves risk, including the possible loss of principal. High yielding stocks are often speculative, high-risk investments. These companies can be paying out more than they can support and may reduce their dividends or stop paying dividends at any time, which could have a material adverse effect on the stock price of these companies and the Fund’s performance. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. The bottom line is; there is no free lunch. If we want the potential for return, we have to take risks.
If this is the early stage of a larger decline, it will unfold with many up and down swings along the way. It will get overbought/oversold over and over and sometimes stay that way longer. I shared it in An exhaustive stock market analysis… continued.
Emotional undisciplined investors, traders, and portfolios managers will be destroyed in a volatility expansion. They’ll swing from the fear of missing out to the fear of losing money as the stock market swings up and down.
Self-discipline and emotional fortitude are essential to be an investment manager.
We’ll see how it all unfolds from here.
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