We don’t usually discuss technical analysis. We are fundamental analysts with a long time horizon. We practice Value investing, looking for companies whose shares are trading cheap relative to earnings and assets. Technical analysts argue that everything that you need to know about future stock prices is embedded in past prices and volume.
But two things related to technical analysis caught our eye recently. First, the VIX Index, or the measure of volatility of price swings in the market, is now at a 24 year low (see chart to the below). One would think that with the Trump election and the level of nervousness among many Americans that volatility would be up, not down. But the S&P 500 has recently enjoyed its longest stretch of avoiding even a 1% daily decline in over two decades.
The second thing that caught our eye is the recent issue of Grant’s Interest Rate Observer which noted that the amount of funds tracking the VIX and basing investment decisions on whether volatility was declining or increasing has jumped dramatically. As volatility declines many of these funds increase their stock exposure and vice versa - when volatility rises they sell and reduce stock exposure.
Grant’s reminded readers that back in 1987 there was a similar strategy called Portfolio Insurance or Dynamic Hedging. This basically was a mathematical formula that called for selling when the market declined and then increased the rate of selling the more the market sold off. This is a logical strategy except for one small problem. When just a few investors are doing this all is well. But if everyone jumps in and tries to do it at the same time, as happened in 1987, then it fails miserably as blind selling leads to even more blind selling.
The fear today is there are too many people focusing on the VIX. Volatility is nothing more than market psychology and as we all know mass psychology can be terribly, ah, volatile. The Financial Times recently noted, volatility is like a spring. The more compressed it becomes, the more energy it has when released.
So why has volatility been so subdued with politics in the world in such turmoil? The Financial Times argues there are three reasons. The first is that Central Banks everywhere have been pumping money into the system at the first sign of a slowdown and this has lowered interest rates, shored up growth and calmed markets.
A second reason is that companies have been buying back their own stock in record amounts, $2 trillion over the past five years. Again this supports market prices and lowers volatility.
A final reason is technical. With more funds chasing the VIX Index and practicing volatility strategies, volatility is driven lower and the result is a self-fulfilling prophesy, at least over the short term.
We are not betting on any sharp market drop today based on Technical signals, but we do not like to see extremes of any kind in the market. Right now we are sensing an eerie calmness on Wall Street. As Grant’s newsletter noted, stability often breeds instability. Do not get lulled into complacency now. Only invest where you are convinced you see real Value. The trend is your friend...except at both ends.