How the VIX Can Help You Time This Market
At heart, I’ve always been a fundamentals guy.
After all, I came up through the boring old mining research industry, where supply and demand rules all.
When prices are high, mining companies spend money to expand production. When they all expand production together, then supply begins to ramp up faster than demand. And finally, when there’s more supply than there is demand, those producers undercut each other’s pricing in order to capture market share.
Then prices fall. Companies lose money and are forced to shut in production — which causes supply to fall.
And finally, when supply falls below demand, prices begin to rise again.
Rinse, repeat.
Or as legendary resource investor Rick Rule often likes to put it, “the cure for high prices is high prices, and the cure for low prices is low prices.”
That old adage is 100% true for commodities. We’ve seen this business cycle play out for as long as we’ve been out there digging holes in the ground.
But since last year’s COVID-19 crash, commodities have been behaving in a vastly different manner.
Demand for oil, for instance, fell to the lowest point in almost a decade — shown in green on the chart below.
Source: DOE, Bloomberg
And yet prices, especially over the past three months, are up almost 60%.
Source: DOE, Bloomberg
Why did that happen?
Well, oil is often inversely correlated to the US Dollar… when the dollar goes down, oil goes up. Not every time, of course, but a lot.
And the medium-term trend here shows that the 90, 120 and 180-day correlation to the dollar all happen to be *really* red, which overlaps with this same time period.
Source: Seawolf Research
And when you look at both on a chart, it is pretty obvious.
Source: Bloomberg
When professional investors notice a trend like that, they will pile into it… and pile they did.
Full disclosure… that took me and my “fundamentals guy” bias by surprise, and I completely whiffed on this price move.
And I’m an energy analyst… I’m not supposed to whiff on this stuff.
But while I was licking my wounds trading oil back in November and December, I managed to figure out one metric that I need to monitor more closely to help make better decisions.
Here’s the chart that tipped me off.
Source: Bloomberg
Oil volatility peaked on Nov. 9 and has been in a clear downtrend ever since.
As volatility (or “vol” as the fund bros say) declines, prices rise. As it increases, prices fall.
Pretty simple.
And better yet, you can apply it broadly across the entire market.
SPY-ing on the SPY
Although we could do this with any stock, I’ll just use the SPDR S&P 500 ETF (NYSEArca: SPY) as an example, because its volatility is literally what comprises the Volatility Index, or the VIX.
Since November, there have been six separate cycles where the VIX spikes up into the 24-28 range briefly, before settling back down in the 20-22 range.
A strategy consisting solely of buying SPY when the VIX spikes and selling when it returns to its baseline level would have returned 18.3% over the past two months, versus just an 8% return for a buy and hold strategy.
Source: Bloomberg
It’s a small sample size, for sure. But when markets are trending higher, it’s a good enough indicator on its own that it should inform us of buying and selling opportunities.
And if we use it in conjunction with the volatility of the VIX itself — or VVIX, as I discussed here back in December — it can be extremely powerful.
And currently, VVIX is telling us all is clear… buy the dang dips and fuhgeddabout it.
Source: Seawolf Research
One of our holdings, however, is losing momentum up near its 52-week highs and moving toward annual lows in volatility… which means we should probably sell.
Source: Seawolf Research
The stock above is DraftKings Inc. (Nasdaq: DKNG) which I recommended picking up in October near its cycle lows.
The reason then was the fact that NFL Football was in full swing, and sports betting was on the ballot in several states — including here in Maryland where it passed overwhelmingly.
With that news largely behind us, growth is likely to decelerate as vaccines roll out, and a valuation largely dependent on states that have yet to legalize sports gambling… Well, it’s time to take a ~30% profit here and put that to work somewhere else.
Who knows, maybe we’ll even short it… but only if the volatility tells us to.
All the best,
Matt Warder