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When can S&P 500 volatility break a stock diversification strategy? Analyze the VIX


S&P 500, VIX index, stock sector diversification, macro – talking points

  • The S&P 500 has 11 sectors to choose from to diversify equity portfolios
  • Broadening exposure is not always perfect to avoid market volatility
  • What levels of VIX undermine this strategy and what can traders do?

What is stock sector diversification?

If an investor wants to diversify exposure in the US stock market, there are many sectors to choose from in the S&P 500. On the pie chart below, there are 11 to choose from ranging from growth-oriented information technology to value-centric industrial firms. To hedge against sector-specific risks, a trader can spread their portfolio between a combination of these.

In such a case, if the S&P 500 hits a bump, losses in one corner of the market can be offset or reduced by gains in another. It might work if all the sectors in the market do not coincide. However, when almost every corner of the index declines in a binary move, a stock diversification strategy becomes increasingly unreliable.

This is not a case against a stock diversification strategy. Rather, it is the analysis of market conditions that have an impact on sectors moving together in the S&P 500. This is done using the CBOE Volatility Index (VIX), also known as the market’s preferred ‘fear meter’. With that in mind, what levels of VIX should traders and investors monitor that run the risk of undermining a stock diversification strategy?

S&P 500 sector breakdown

What is the VIX and why should traders look at it?

The VIX was created in 1990 to be used as a benchmark for analyzing volatility projections in the US stock market. It trades in real time, reflecting the expectations of the price movement over the next 30 days. As such, it tends to have a very close inverse relationship with the S&P 500. In other words, as stocks fall, the VIX rises and vice versa. For a deeper dive into the VIX, see a complete guide here.

This inverse relationship can be seen in the following graph, which shows the average S&P 500 performance compared to equivalent VIX levels since 2002. For the study, average weekly data are used to calculate monthly outcomes. This is done so that it helps reduce the ‘volatility of volatility’, while a monthly reading can run into the data that does not capture the broader trend.

Looking at the data, April tended to see the most optimistic performance for the S&P 500, averaging 2.06%. Thereafter, this performance declined before reaching a low in October, when the benchmark stock index returned about -0.1%. During this period we saw the VIX climb, which started at 18.30 in April, and then rose to 21.23 in October. If we know this, we can now look at what’s happening inside the S&P 500.

VIX versus the S&P 500

When can S&P 500 volatility break a stock diversification strategy?  Analyze the VIX

S&P 500 Cross-sector correlations with the VIX

To see when a stock sector diversification strategy can fail, we will need dedicated price indices from the 11 sectors in the S&P 500. The data used for the latter go back only to 2002. We can then calculate correlation levels between the VIX and for each sector using a one-month rolling basis. The correlations vary between -1 and 1. A -1 reading means perfect inverse movements between two variables, while 1 is perfect unanimity.

The average of all 11 outcomes in each period provides a cross-sector correlation reading with the VIX. The correlations are then separated into groups ranging from strong (-1 to -0.75), medium (-0.75 and -0.50) and weak (all values ​​greater than -0.5). A strong reverse reading reflects the VIX rising / falling as sectors fall / climb along with the most consistency. Weaknesses represent sectors that move more freely.

In 7 out of 12 months, higher levels of VIX were associated with stronger cross-sector inverse correlations with the ‘fear meter’. For example, the average weekly price of the VIX in March was 26.55 when the S&P sectors moved most in harmony. The price dropped to 15.28 when we saw sectors move more freely. If you know, what levels of VIX could undermine a cross-sectoral diversification strategy?

VIX Price Versus Different Levels of S&P Cross-Sector Inverse Correlations

When can S&P 500 volatility break a stock diversification strategy?  Analyze the VIX

When can a stock sector diversification strategy fail?

We can now average the prices of the VIX for all months and years since 2002 based on the 3 correlation groupings. At the same time, we will average the weekly performance of all the S&P sectors and align them based on the same categories. On the graph below we can see that the outcome was quite predictable. Stronger inverse correlations with the VIX in line with increasingly weaker performance between sectors.

When we saw that all the sectors were moving the most towards the VIX, the average price of the ‘fear meter’ was 22.85. When this happened, the average yield of each sector was -0.47%. Conversely, when the sectors moved more freely relative to the VIX, the price of the latter was 16.72. At that price, the average return between each sector was + 1.08%.

It should be noted that correlation does not imply causality. Just because the VIX is at some arbitrary price does not mean that it is the only cause of trade dynamics between sectors. Rather, it is used here as a frame of reference. What actually causes markets to fall into binary shifts is a combination of fundamental factors: monetary policy, fiscal spending, company guidance and more.

What can traders do about volatility?

If you know this information, what can traders do when they expect high volatility and strong cross-correlations across market sectors? High eruptions of volatility are often short-lived and temporary. During these times, refuge-oriented assets tend to perform better. This includes the US dollar, which often rises during times of global market stress. Short sale shares is another. Scaling down exposure to current and new businesses also helps. The combination of these can help prepare traders for some bumpy roads.

VIX Price Versus Performance of S&P 500 Sectors Based on Correlation Groupings

When can S&P 500 volatility break a stock diversification strategy?  Analyze the VIX

— Written by Daniel Dubrovsky, Strategist for techlives.in

To contact Daniel, use the comments section below or @ddubrovskyFX on Twitter

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