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When Can S&P 500 Volatility Break a Stock Diversification Strategy? Analyze the VIX – By ASC


S&P 500, VIX Index, Stock Sector Diversification, Macros – Discussion Items

  • The S&P 500 has 11 sectors to choose from to diversify its stock portfolio
  • Expanding exposure is not always perfect for avoiding market volatility
  • What are the levels of the VIX that affect this strategy and what can traders do?

What is Stock Sector Diversification?

If investors want to diversify their exposure in the U.S. 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 that range from growth -oriented information technology to firm value -centric industries. To hedge against sector -specific risks, traders can spread their portfolios among several of these combinations.

In such cases, if the S&P 500 hits a surge, losses in one corner of the market may be offset or offset by gains in another corner. This may work if all sectors in the market do not fall simultaneously. However, as almost every corner of the index declines in a binary movement, stock diversification strategies become increasingly unreliable.

This is not the case with stock diversification strategies. Instead, it analyzes the conditions in the market that affect the sectors moving along in the S&P 500. This is done using the CBOE Volatility Index (VIX), also known as the ‘fear gauge’ of market options. So, what is the level of the VIX that traders and investors should keep in mind that risk affects stock diversification strategies?

S&P 500 Sector Breakdown

What is the VIX and Why Should Traders Watch It?

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

This inverse relationship can be seen in the next chart, which shows the average performance of the S&P 500 versus the equivalent VIX level since 2002. For the study, average weekly data was used to calculate monthly yields. This is done so that it helps avoid trimming ‘volatility’, while monthly readings can cause data to fail to capture broader trends.

Looking at the data, April tends to see the most optimistic performance for the S&P 500, averaging 2.06%. Subsequently, the performance tapered before reaching a low point in October, when the benchmark stock index returned about -0.1%. During this period, we saw the VIX climb, starting at 18.30 in April, then rising to 21.23 in October. Knowing this, we can now see what is happening in the S&P 500.

VIX Versus S&P 500

When Can S&P 500 Volatility Break a Stock Diversification Strategy?  Analyze the VIX

The S&P 500 Cross -Sector Correlation with the VIX

To see when a stock sector diversification strategy can fail, we need a specific price index for 11 sectors in the S&P 500. The data used for the latter only goes back to 2002. We can then find the level of correlation between the VIX and for each sector using a rolling basis one moon. Correlations range between -1 and 1. A reading of -1 means a perfect inverse movement between two variables, while 1 is a perfect combination.

The average of all 11 results in each period offers cross -sector correlation readings with the VIX. Next, correlations were separated into groups between strong (1 to 0.75), moderate (0.75 and 0.50), and weak (all values ​​greater than 0.5). Strong inverse readings reflect the VIX up/down when the sector goes down/up along with the most consistent. The weaker ones represent a sector that moves more freely.

In 7 of 12 months, higher VIX levels were associated with a stronger cross -sector inverse correlation with the ‘fear gauge’. For example, the weekly average price of the VIX in March was 26.55 when the S&P sector moved the most simultaneously. The price dropped to 15.28 as we saw the sector move more freely. Knowing this, what are the levels of the VIX that can affect cross -sector diversification strategies?

VIX Prices Against Different Levels of Inverse Correlation Across the S&P Sector

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 VIX prices for all months and years since 2002 based on 3 correlation groups. At the same time, we will average the weekly performance of all S&P sectors and adjust them based on the same categories. On the chart below, we can see that the results are quite predictable. The stronger inverse relationship with the VIX is in line with the deteriorating performance between sectors.

When we look at all the sectors moving most in opposition to the VIX, the average price of the ‘fear gauge’ is 22.85. When this happens, the average return per sector is -0.47%. On the other hand, when the sector moves more freely than the VIX, the price of the second sector is 16.72. At that price, the average return between each sector is +1.08%.

It should be noted that the correlation does not indicate a cause. Just because the VIX is at an arbitrary price does not mean it is the sole cause of the dynamics of inter-sectoral trade. Instead, it is used here as a frame of reference. What actually causes the market to fall in the binary movement is a combination of fundamental factors: monetary policy, fiscal spending, company guidance and more.

What Can Traders Do About Volatility?

Knowing this information, what can traders do when anticipating high volatility and strong cross -correlations across market sectors? High volatility is often short -term and temporary in nature. Currently, heaven -oriented assets tend to outperform performance. This includes the US Dollar, which often increases during global market pressures. Short sale stock is another. Reducing re -exposure to current and new ventures also helps. Combining this can help prepare traders for some bumpy roads.

VIX Price Versus S&P 500 Sector Performance Based on Correlation Group

When Can S&P 500 Volatility Break a Stock Diversification Strategy?  Analyze the VIX

— Written by Daniel Dubrovsky, Strategist for DailyFX.com

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

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