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Do Not Fear the Fear Index

2022-11-18, Daniel Morgan

Many investors have taken significant losses in their portfolios this year and fear the situation could worsen if the economy goes into recession. We see investor jitters expressed in higher than usual market volatility. There are several measures of volatility out there, but none more frequently referenced than the VIX Index. It tracks the expected 30-day volatility of the US stock market, derived from options prices in the S&P 500. Higher levels mean there is more uncertainty about the near future, hence the VIX is also known as the “fear index.”

As we can see in Chart 1, the market can go through extended periods of calm, as evidenced by a low VIX level. At the other extreme, the VIX spikes during crises, such as the Global Financial Crisis and Pandemic Panic.

Source: Chicago Board Options Exchange, QV Investors

It can be emotionally difficult to stay invested during periods of high volatility, but the data is encouraging for those who do. After periods of elevated market tumult in which the VIX is extremely high, the probability of further losses goes down and the chances of positive returns rises. Using data from 1990 to the present, Chart 2 shows the relationship between the five-day average VIX level and one-year forward returns of the S&P 500. As you can see, investors are usually rewarded in proportion to the pain they have recently endured, sometimes with one-year stock market recoveries up to 75%.

Source: Chicago Board Options Exchange, S&P Capital IQ, QV Investors

During 2022, we have seen the VIX close above 25 in more than half of all trading days. The last time we have seen the fear index persistently above that level was in 2020 and before that, in 2008 and 2009 (Chart 3).

Source: Chicago Board Options Exchange, QV Investors

If we examine the market data only in the periods in which the VIX was above 25 for at least a week, we can see a favourable distribution of one-year forward returns, which are positive 85% of the time, and with returns skewed to the upside (Chart 4).

Source: Chicago Board Options Exchange, S&P Capital IQ, QV Investors

Hopefully, the data here illustrates the vital importance of staying invested since the odds tilt in a long-term investor’s favour. The late financier and statesman Bernard Baruch, reflecting on his experience investing in both bull and bear markets, instructed in his memoir:

“Don’t try to buy at the bottom and sell at the top. This can’t be done — except by liars.” -Bernard Baruch

Market gyrations create opportunities for investors willing to focus on the long game rather than retreating in the face of fear. While volatility is high right now, QV’s investment team is asking each other where they are seeing the best long-term opportunities. This seems to contrast with what we have heard from market strategists about how the two most frequently asked questions they get concern when the market bottom might come and what to buy or sell to outperform in the next two or three months.

One example involving the QV Canadian Equity Strategy where we are more focused on the multi-year opportunity and less about its weak performance in 2022 is Brookfield Asset Management (BAM). We have conviction that net of debt, its unique portfolio of assets with predictable cash flows is worth more than its market valuation, supported by its ability to compound capital at above-average rates through cycles. Brookfield’s owner-operator business model and the nature of the assets it specializes in (infrastructure, real estate, private equity, and credit) necessitates it to assume a lengthy investment horizon, often making it a buyer in areas where selling might be more popular. Though our team respects the reasons why others may be sellers of BAM, we believe uncertainties about macroeconomic forces are the dominant narrative such that the risks priced into it are likely outweighed by the rewards it could yield over many years.

We cannot, nor can anyone else, gain privileged access to the future or accurately call an end to market losses. Though we are generally optimistic about the future, QV attempts to “BE PREPARED”, per the words inscribed on Baruch’s memorial in Washington, D.C., by contemplating not just the upside, but also the downside, when evaluating the attractiveness of any investment.

All views and projections are the expressed opinion of QV Investors Inc. and are subject to change without notice. This Update is provided for informational purposes only. QV Investors takes no legal responsibility from any losses resulting from investment decisions based on the content of this Update.


Daniel Morgan | Research Associate

Daniel analyzes investment opportunities and monitors existing holdings for the Canadian large cap strategy.