Fat Wallets and Fat Tails
Cool chart
The Volatility Index (VIX) is computed by the Chicago Board of Options Exchange. This gauge is the de facto standard for measuring and tracking equity market volatility, and many consider it to be the “fear gauge” for stocks.
The VIX works by measuring the implied volatility in near-term put options on the S&P 500. The higher the volatility in these options, the higher the VIX and media coverage surrounding the VIX.
Here’s a cool chart that I found this week. When the VIX is above 30, it tends to be bullish BUT the tail risk also increases. Stay with me because this may get a little geeky…
VIX below 12 is the tallest and slimmest distribution. It represents the times when clients sleep the best and are happiest because it’s quiet.
But notice how the right side from the average (peak) is steeper (falls faster) than the left side`. This implies that periods of low volatility have a higher probability of future downside than upside, and when there is upside, it’s not as much.
Low volatility having more downside risk may seem counterintuitive, but the VIX is a “mean-reverting” index. Meaning, when it is below its long-term average, it tends to rise to that average (around 18-20 depending on the timeframe). Volatility also acts like a compressed spring, where the farther down it goes and the longer it stays there, the more violent the release
VIX above 30 has a higher average (peak is further to the right than the other two peaks) with a wider distribution (larger range of possible outcomes) AND “fatter” tails (the height of the two tails off the y-axis).
This implies that high volatility is bullish for stocks BUT also increases the risk of black swans like March 2020, GFC, etc. No matter what your time horizon, these are the events that nobody in their right mind wants to be invested through.
However, don’t forget there are two tails. The one on the left is where black swans live, but the one on the right is really awesome for bulls. These are the bumper returns in stocks that make us all feel like geniuses and invincible to loss.
Herein lies the challenge as an allocator. As much as you want to avoid the left tail, you don’t want to do anything that eliminates the opportunity to participate in the right tail.
If you’re using our Aptus strategy, it’s all about trying to do just that. Seize these opportunities but don’t go in blind like Modern Portfolio Theory (MPT) would suggest. Employ over 100 servers to provide the computing power necessary to execute advanced mathematics that aim to incorporate this tail risk into an allocation.
It’s good to live here
We’ve talked about how net worth for Americans has exploded over the last two years and not just for the rich. Here’s more detail to show how and where that net worth increased.
Americans’ total net worth at the end of 2021 was $35.5 trillion, or 29% higher than at the end of 2019. This is due to higher asset prices (stocks and home equity) but also reduction in debt. Yes, Uncle Sam paid for a lot of Louis Vuitton bags, but those stimmy checks also went to debt reduction.
The net result is a massive wealth effect for each group in the chart above. For example, Americans in the bottom 60% of the income distribution have experienced a 24% increase in their holdings of cash and equivalents since the end of 2019 as well as a 30% increase in their home equity.
Perhaps this will dampen or delay the negative consequences of inflation. The reason I say that when debts go down, it’s almost always at the expense of savings, but not this time. There’s $2.4 trillion in excess savings right now that remains mostly untapped. That’s a lot of firepower for Americans.
Disclosures
This newsletter/commentary should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful.