By Chad Shoop
“What are we going to do when the market crashes?”
It was one of the first conversations I had while we were in Bermuda for our annual Total Wealth Symposium, but it was far from the last time this topic came up. In fact, there were many more attendees who asked the same exact thing.
When posed this question, I had to give an impromptu response. As a result, most attendees’ eyes glazed over as I dove into market dynamics and current market trends.
That’s not what they wanted to know.
What they were really concerned about wasn’t how I am managing the coming crash within a particular service, but how they, and others, could avoid a crash like we saw in 2008 when it happens again.
Today, I’ll give you the best, and most conservative, way to do so by following one simple indicator: volatility.
Specifically, I’m talking about the CBOE Volatility Index (INDEXCBOE:VIX) — aka the fear index.
Basically, this index measures the implied volatility of options on the S&P 500 Index. It gets the name “fear index” because the index spikes as investors rush into S&P 500 put-option buying as a means of crash protection. The higher the index rises, the more worried investors are of a market crash.
This concept holds true in practice based on data showing the VIX surging in times of panic as the S&P 500 plunges.
Watching the VIX can be a simple means of keeping your wealth out of harm’s way, like in the 2008 global recession. But it can also help you grow your portfolio as the markets rally. Let me explain…
Throwing the VIX in the Mix
As with any sort of index, different VIX levels tell us different things about the market — that’s how we are going to determine when to be invested and when not to be.
VIX lows currently hover around 10 to 13. While that’s not important for our current topic, it will help you understand that any single-digit to low-teens VIX reading means investors are not fearful at all.
Once the VIX breaks above 20, the index is signaling that investors are concerned about the market. They might even be taking a little money off the table at this point.
When the VIX is above 30, it’s likely that the S&P 500 has suffered a correction (a drop of at least 20%), and investors are starting to panic.
When the VIX is significantly beyond 30, investors are definitely panicking, and the S&P 500 is in collapse territory. At this point, investors are selling everything in their portfolios just to stop the bleeding. They no longer care what price they get out at. They just want out. That kind of panic selling tends to feed upon itself, sending the market spiraling lower for an extended period of time.
To avoid a collapse, I ran a simple backtesting strategy where you would buy the S&P 500 only when the VIX was below 25 — meaning investors weren’t in all-out panic mode just yet. Then, once the VIX crossed above 25, you would sell and cash out.
The results from the past 15 years show that following this strategy you would have generated a 70% overall return. However, the S&P 500, as tracked by the SPDR S&P 500 ETF (NYSE Arca: SPY), was up 85% over the past 15 years — so, an underperformance of 15 percentage points.
At first, this looks like a bad investment strategy. But the underperformance is mainly due to the fact that it takes some time for the VIX to settle back down below 25 after a surge in volatility.
However, the benefits of using an indicator like this is that you miss out on the worst of the stock market’s declines. For example, following this strategy and exiting once the VIX crosses 25, you would have moved to cash on September 12, 2008 — just ahead of a 45% stock market plunge.
So, even though your overall return was smaller, your risk exposure was much smaller. Avoiding that 45% decline makes this strategy worthwhile by allowing you to sleep better at night knowing you missed the worst of it.
The Only Thing We Have to Fear
While my response at the conference was a bit long-winded, the gist of it is that if you are concerned about a market crash that meets or exceeds 2008, the VIX is the indicator you want to follow.
Simply move to cash as it climbs above 25, and look to get back in once it drops back below that level.
I’ll add a sidenote to this: This is not the approach I’ll be taking when it comes to my services. That’s because most of our services are designed to thrive regardless of the market direction — in fact, Pure Income will perform even better and collect even more income when volatility rises.
When the shift from bull to bear market happens, returns may take a negative hit in the transition. But once a trend is in place, all our systems begin to capitalize on the new market trend and grow your capital even in bear markets.