[ad_1]
S&P 500, VIX Index, Stock Sector Diversification, Macro – Talking Points
- The S&P 500 has 11 sectors to choose from to diversify your stock portfolio
- Increasing risk exposure is not always perfect to avoid market volatility
- Which VIX levels are disrupting this strategy and what can traders do?
What is Stock Sector Diversification?
If investors are looking to diversify their exposure to U.S. stocks, there are many sectors in the S&P 500 to choose from. There are 11 companies to choose from in the pie chart below, ranging from growth-oriented information technology to value-oriented industrial companies. To hedge against industry-specific risks, traders can diversify their portfolios through these combinations.
When the S&P 500 takes a hit in this situation, losses in one corner of the market can be offset or reduced by gains in another. This may have worked if not all sectors of the market fell at the same time. However, when almost every corner of the index is falling in binary fashion, equity diversification strategies are becoming less reliable.
This is not against equity diversification strategies. Instead, it analyzes market conditions affecting industries that move together in the S&P 500. This is done using the CBOE Volatility Index (VIX), also known as the market’s favorite “fear gauge.”
S&P 500 Sector Breakdown
What is the VIX and Why Should Traders Watch it?
The VIX was created in 1990 as a benchmark for analyzing forecast volatility in the U.S. stock market. It is traded in real-time and reflects expectations for price action over the next 30 days. As such, it tends to have a very close inverse relationship with the S&P 500. In other words, when a stock falls, the VIX rises and vice versa. For an in-depth look at VIX, check out the full guide here.
This inverse relationship can be seen in the next chart, which shows the average performance of the S&P 500 since 2002 and the corresponding VIX levels. The study used average weekly data to calculate monthly results. This is done to avoid truncation of “volatility of volatility,” and monthly measurements can get bogged down in data that doesn’t capture broader trends.
Judging from the data, the S&P 500 was the most optimistic in April, with an average gain of 2.06%, and then gradually retreated, bottoming out in October, when the benchmark stock index rose about -0.1%. During this period, we saw the VIX rise starting at 6:30pm in April and then rising to 9:23pm in October. Armed with this knowledge, we can now look at what happened to the S&P 500.
VIX Versus the S&P 500
S&P 500 Cross-Sector Correlations with the VIX
To understand when equity sector diversification strategies fail, we need a dedicated price index for the 11 sectors in the S&P 500. The latter uses data that only goes back to 2002. We can then find the level of correlation between the VIX and each industry on a rolling month basis. Correlation ranges from -1 to 1. A value of -1 means complete opposites between the two variables, while 1 means complete agreement.
Averaging all 11 results for each period provides a measure of cross-industry correlation with the VIX. Next, the correlations were divided into groups of strong (-1 to -0.75), moderate (-0.75 and -0.50), weak (all values greater than -0.5). Strong inverse readings reflect a rise/fall in the VIX as these sectors fall/rise in line with the most consistent extent. Weaker reps move more freely.
In 7 of the 12 months, higher VIX scores were associated with a stronger cross-industry negative correlation with the “measure of anxiety.” For example, the average weekly price of the VIX was 26.55 in March, when the S&P sector collectively moved the most. Prices fell to 15.28 as we see sectors move more freely. Knowing this, which VIX levels would undermine a cross-industry diversification strategy?
VIX Price Versus Different Levels of S&P Cross-Sector Inverse Correlations
When Can a Stock Sector Diversification Strategy Fail?
We can now average VIX prices for all months and years since 2002 based on 3 relevant groupings. At the same time, we will average the weekly performance of all S&P sectors and adjust them for the same categories. In the chart below, we can see that the results are completely predictable. A stronger inverse correlation with the VIX correlates with worsening performance across sectors.
When we see the most volatility across all sectors against the VIX, the average price of the “fear gauge” is 22.85. When this happened, the average return for each industry was -0.47%. Conversely, when the sector moved more freely relative to the VIX, the latter traded at 16.72. At this price, the average return between sectors is +1.08%.
It is important to note that correlation does not imply causation. Just because the VIX is priced randomly, doesn’t mean it’s the only reason for the momentum to trade across industries. Instead, it serves as a frame of reference. What actually drives the market down in a binary fashion is a combination of fundamentals: monetary policy, tax spending, business forecasts, and more.
What Can Traders Do About Volatility?
Given this information, what can traders do if they expect high volatility and strong cross-correlations between market sectors? Volatility spikes are usually short-lived and temporary. Safe haven-focused assets tend to outperform during these times. That includes the U.S. dollar, which typically rises during times of global market tension. Shorting stocks is another matter. Reducing exposure to existing and new business also helps. A combination of these factors can help traders prepare for some rough roads.
VIX Price Versus Performance of S&P 500 Sectors Based on Correlation Groupings
[ad_2]