When can the S & P 500 volatility break the equity diversification strategy? VIX analysis

S & P 500, VIX Index, Equity Sector Diversification, Macro-Issues

  • The S & P 500 There are 11 sectors to choose from to diversify your equity portfolio
  • Expanding your exposure is not always perfect to avoid market volatility.
  • What level of VIX can undermine this strategy and what can traders do?

What is Equity Sector Variance?

If investors want to diversify their exposure on the US stock market, the S & P 500 has many sectors. In the pie chart below, there are 11 choices that range from growth-oriented information technology to value-centric industries. Company. To hedge sector-specific risks, traders can diversify their portfolios between these combinations.

In such cases, if the S & P 500 soars, losses in one corner of the market may be offset or reduced by profits in another corner. This can work if all sectors of the market do not match. However, if almost every corner of the index is diminished by binary movements, the equity diversification strategy becomes increasingly unreliable.

This is not the case with equity diversification strategies. Rather, it analyzes market conditions affecting the sectors that work together on the S & P 500. This is done using the CBOE Volatility Index (VIX), also known as the market’s favorite “fear gauge”. With that in mind, at what level of VIX do traders and investors need to monitor the risks that undermine their equity diversification strategies?

Breakdown of S & P 500 sector

What is VIX? Why do traders need to see it?

VIX was created in 1990 for use as a benchmark for analyzing volatility forecasts on the US stock market. It will be traded in real time, reflecting the expected price fluctuations over the next 30 days. Therefore, it tends to be in a very close inverse proportional relationship with the S & P 500. In other words, when the stock price goes down, VIX goes up, and vice versa. To dig deeper into VIX Check out the complete guide here..

The opposite relationship can be seen in the following graph showing the average performance of the S & P 500 compared to comparable VIX levels since 2002. This study uses weekly average data to calculate monthly results. This is done to avoid truncation of “volatility volatility”, but monthly reads may come across data that cannot capture a wider range of trends.

Looking at the data, April’s S & P 500 performance tended to be the most optimistic, averaging 2.06%. After that, this performance gradually declined before it bottomed out in October when the benchmark stock index returned about -0.1%. During this period, VIX started at 18.30 in April and rose to 21.23 in October. Knowing this, you can see what’s happening inside the S & P 500.

VIX and S & P 500

When can the volatility of the S & amp; P 500 break the equity diversification strategy? VIX analysis

Inter-sector correlation between S & P 500 and VIX

To see if your equity sector diversification strategy can fail, you will need the S & P 500’s 11-sector dedicated price index. The data used for the latter dates back to 2002. You can then find VIX and each correlation level. A sector that uses a one-month rolling base. The range of correlation is -1 to 1. A reading of -1 means the exact opposite movement between the two variables, and 1 means an exact match.

Averaging all 11 results for each period provides a reading of the sector-to-sector correlation with VIX. The correlations are then divided into groups ranging from strong (-1 to -0.75), medium (-0.75 and -0.50), and weak (all values ​​greater than -0.5). The strong reverse reading reflects that VIX went up / down when the sector dropped / climbed most consistently. Weak ones represent more free-moving sectors.

In 7 of the 12 months, the higher the VIX level, the stronger the inverse correlation between the sectors with the “fear gauge”. For example, the average weekly price of VIX in March, when the S & P sector moved most consistently, was 26.55. The price dropped to 15.28 when we saw the sector move more freely. Knowing this, what level of VIX could undermine the intersectoral diversification strategy?

Inverse correlation between VIX prices and various levels of S & P sectors

When can the volatility of the S & amp; P 500 break the equity diversification strategy? VIX analysis

When can a diversification strategy in the equity sector fail?

You can now average VIX prices for all months and years since 2002 based on three correlation groups. At the same time, it averages the weekly performance of all S & P sectors and adjusts based on the same category. In the graph below, you can see that the results are fairly predictable. A stronger inverse correlation with VIX is consistent with poor performance between sectors.

The average price of the “fear gauge” was 22.85 when we saw all sectors move most in the opposite direction to VIX. When this happened, the average return for each sector was -0.47%. Conversely, if the sector moved more freely than VIX, the price of the latter was 16.72. At that price, the average return between sectors was + 1.08%.

Note that correlation does not mean causality. Just because VIX is an arbitrary price does not mean that it is the only cause of trading dynamics between sectors. Rather, it is used here as a reference frame. The actual alternative cause of market decline is a combination of basic factors such as monetary policy, fiscal spending and corporate guidance.

What can traders do about volatility?

With this information, what can traders do if they expect high volatility and strong cross-correlation across the market sector? Highly volatile bursts are often short-lived and temporary. During these times, shelter-oriented assets tend to outperform performance. This is USD, This often rises during stress in the global market.. Hot selling stocks It’s different. Reducing the exposure of current and new businesses can also help. Combining these will help traders prepare for bumpy roads.

VIX price and performance of S & P 500 sector based on correlation group

When can the volatility of the S & amp; P 500 break the equity diversification strategy? VIX analysis

— Written by Daniel Dubrovsky, Strategist For

To contact Daniel, use the comments section below or @ddubrovskyFX On twitter

When can the S & P 500 volatility break the equity diversification strategy? VIX analysis

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