Stock Market's Soaring Volatility Mirrors 1987 Crash

After an extended period at near-historic lows, stock market volatility is on the rise, making some people with long memories a bit nervous. Now a managing director at UBS Financial Services, as well as an executive floor governor of the NYSE, Art Cashin has worked in the securities industry since 1959. As he told CNBC: "It's a good deal more volatile than almost anything you've seen. It is unfortunately reminiscent of some of the volatility we saw in '87." Meanwhile, as Christopher Stanton, chief investment officer of California-based Sunrise Capital LLC told The Wall Street Journal: "The new safe haven is volatility. It's the one thing that's pretty much guaranteed."

Flashback to 1987

While recent market action is stirring up memories of the 1987 stock market crash for Cashin, the downdrafts experienced so far in 2018 are modest by comparison. On October 19, 1987, soon dubbed Black Monday, the Dow Jones Industrial Average (DJIA) plummeted by a breathtaking 25.3% from the previous close, eventually rallying to end the day at 22.6% loss. By comparison, the biggest single-day decline in the Dow so far in 2018 was a 6.2% decline in intraday trading on February 5, eventually ending the day down by 4.6% from the close of the previous trading session.

The CBOE Volatility Index (VIX), often called a fear gauge for the market, did not exist in 1987. But computer-driven program trading was a major factor in creating an avalanche of sell orders that swamped the market. Today there is a different name, algorithmic trading, for the same concept. Advances in computing speed and power have made it even more of a danger, however. (For more, see also: Could Algo Trading Cause a Bigger Crash Than 1987?)

Profiting From Volatility

The VIX is up by 95% from the start of the year through the close on April 6, per Yahoo Finance. Its 2018 peak was reached in intraday trading on February 6, up 356% from the 2017 close. 

Stanton of Sunrise Capital, per the Journal, is among those who are buying futures contracts tied to the VIX, betting on increased volatility that will lift their values. He is among a growing number of hedge fund and other asset managers who have been doing the same in the last two weeks, per CFTC data cited by the WSJ. Moreover, since the VIX typically rises when stocks fall, this strategy also can serve as a hedge against sudden drops in share prices, the Journal notes. As an example of recent gains for this strategy, an ETF tracking VIX futures was up by 68% year-to-date through April 5, per FactSet Research Systems data cited by the WSJ.

Don't 'Bleed Away Money'

But, the Journal warns, "Investors must time the bets with precision, and be equally adept at cashing out at the right moment." Moreover, buying volatility can be expensive. According to Salil Aggarwal, an equities derivatives analyst at Deutsche Bank: "It's very hard to make money being systemically long volatility. Over time you're going to bleed away money."

Don't Forget the Recent Past

Earlier this year, the supposedly can't-miss bet was exactly the opposite, on the continuation of the historically low volatility that reigned throughout 2017. Speculators who played that game eventually racked up huge losses, wiping out previous gains. Funds and complex securities built on this premise cratered in value, with many of them effectively producing total losses in the end. (For more, see also: 6 Forces That May Push the Stock Market Even Lower.)

Mixed Messages

Low volatility worried some observers. Based on the premise that low values of the VIX indicated low levels of fear among investors, these pundits warned of dangerous complacency that encouraged excessive risk-taking. That, they said, eventually would lead to a market crash. During the stock market correction in early February, Francesco Filia, CEO of London-based Fasanara Capital Ltd., expressed such opinions. (For more, see also: Low Volatility May Spur Stock Market Crash: Filia.)

However, Filia also claims that increased volatility is a red flag for stocks. The Fasanara Capital website currently has a box entitled "Latest Comment: VIX volatility shock is an early warning signal that markets are approaching a crucial tipping point," containing a CNBC Europe clip in which he makes this opposing assertion. No doubt inadvertently, he illustrates the limitations and ambiguities of the VIX as a forecasting tool.

What to Do

For more unambiguous advice, one might look to master investor Warren Buffett. He believes that volatility is short-term noise that should not concern the long-term, value-oriented, investor at all. Echoing Buffett, the Journal has advised investors to stay diversified and reduce downside risk, while recognizing that volatility is normal, that avoiding it is costly, and that it offers opportunities for finding bargains. (For more, see also: Strategies to Volatility-Proof Your Portfolio.)

Buffett also warns against ever buying stock on margin, a view that is especially germane in times of high volatility. Market dips can trigger margin calls that force you to sell attractive long-term investments prematurely. (For more, see also: Buffett Warns Investors To Avoid Borrowing Money To Buy Stocks.)

The director of research at mutual fund rating service Morningstar Inc. suggests that investors react to increased volatility by pivoting their portfolios toward small-cap value stocks and dividend payers. He also recommends measures aimed at inflation protection and risk reduction. (For more, see also: Stock Strategies for a Highly Volatile Market.)

Financial columnist Mark Hulbert has had a long career scrutinizing the track records of investment advisory newsletters, and the validity of investment research studies. He cites research indicating that low volatility stocks often deliver higher long-run returns. (For more, see also: 10 Low Volatility Stocks for Wild Markets.)