As we turn to the time of the year when history shows the most stock market corrections having taken place, the questions naturally arises, will 2017 be one of those years? An honest answer of course is: nobody knows. The savviest professional investors don’t know either. They estimate the chances of a correction and incorporate it into their strategy.
After a record bull market run, most every stock is above levels of the 2009 debacle. It is a safe statement that there are a record number of investors with generous paper profits in their portfolios.
This year alone the market has risen over 10%. Super stocks like NVIDIA have been up over 150%. Stock market sentiment indicators show that investors are filled with glee, the most in years.
The temptation is to check your portfolio as often as you check you email, constantly watching. It can trap you into a state of greed and this is dangerous.
But eventually markets correct and this one is no different. The question is how to protect yourself against the inevitable. If you are young and just getting started most financial advisors will tell you not to worry about short-term price changes. Virtually every long term study supports this recommendation.
But what if you are blessed with assets but cursed with advancing age? What if your retirement plan has less then 10 years before being activated? This is where investment planning changes. No portfolio is bullet proof so being overconfident and complacent can be costly.
Things To Consider
You could rush out and sell your highest priced most overvalued stocks. The IRS would love you for that. They would collect a nice tax. To overcome a 15% capital gains tax, you have to achieve a 30% investment return to get back to the same capital level. A 15% stock market correction would be uncharacteristically severe. Even if you switch asset allocation you are likely to run into some taxable event.
Stock and Index options are alternatives used by many professionals. This usually involves selling options that can put you in a position of paying large premiums or even taking short selling risks. Unless you are experienced in the world of options or work with a bona fide expert, options can be a quick path to trouble.
Research the VIX
Instead of doing all the math calculations basic to options, consider the VIX. It is a measure of implied volatility of the S&P 500 Index options so it does all the calculating for you. When you buy the VIX there is no short seller risk, only long side risk. The VIX runs counter to the general market. It is popularly known as the fear index so it can be an effective hedge with little taxable consequences.
For those who are interested in doing deep research, here is how the VIX is calculated. The VIX is the square root of the risk-neutral expectation of the S&P 500 variance over the next 30 calendar days. The VIX is quoted as an annualized standard deviation. Now that this is perfectly clear, we can move on.
Lately Serenity Is Turning To Agita
After years of calm, the VIX is starting to stir.
Since the financial crisis when the VIX shot up almost overnight to a high of 60, the index fell to a low around 6 during the summer. This is what happens when stock prices are rising and investors are feeling good.
There have been just two brief days when the index has poked its head above 30. Since May 2012, the VIX has been hanging out between 10-20. If you are getting the picture of a downward sloping trend line, you are getting the right message.
But since late April, things have been changing. The volatility of the index that measures investor fear has been getting agita shooting up over 50% from record lows on three occasions before falling back.
As we move into the seasonally volatile period for the stock market the VIX is just something to put up on your stock screen and keep an eye on. You never know.