Time to add the VIX to your equity portfolio?

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The interim solving of the debt crisis in Greece has restored calm in the markets, with the CBOE S&P 500 Volatility Index (VIX) settling at 17.3 compared to its long-term average of 20.0. The big question now is whether the VIX will return to the low levels of 1991-1996 and 2004-2006.

Sources: CBOE; Plexus Holdings.

But why is it important? The two periods mentioned coincided with sustained strong rising equity markets. Let us take a look at the period 2004 to end 2006. The VIX fell to an average of approximately 13 over that period, while valuation levels as measured by Robert Shiller’s PE10 increased significantly. Please note that in the graph below I used the inverse of the PE10, which is in fact the earnings yield or EY10. The period was marked by strong steady global economic growth on the back of China’s fortunes, strong corporate profit growth and a significant increase in risk appetite.

Sources: Robert Shiller; CBOE; Plexus Holdings.

At this stage the market’s rating reflects the VIX, but where to now? While similar strong economic growth etc. may await us further down the road the same cannot be said for the next two years, let alone this year, as the weak global economic environment (a much weaker Chinese economy, the Eurozone’s continued woes and the relatively weak U.S. economy)  is likely to persist. I am therefore of the opinion that a VIX of around 20 and a PE10 of 22 can be seen as fair value. These compare with the current VIX of 17.3 and PE10 of 22.6. Yes, optimism may drive the VIX down to 15 again and the PE10 to 25 but to me that will indicate a significant selling opportunity. Similarly, the more regular occurrence of black swans has led to a significantly changed investment environment. Yes, it has led to the VIX being more volatile than in the past.

So much for volatility, but what about the underlying economic fundamentals? I have often referred to the relationship between consumer confidence and market valuation. Consumer spending is the backbone of the U.S. economy and is therefore the reason why consumer confidence gauges are closely watched by the major market players. At this stage it is evident that the S&P 500 Index at a PE10 of 22.6 is fully reflecting the Conference Board Consumer Confidence Index and therefore the underlying economy as it stands.

Some may argue that the employment situation in the U.S. remains dire and is likely to lead to another fall-off in consumer confidence. Well, my research indicates that consumer confidence in fact leads the U.S. unemployment rate by approximately nine months. With the Conference Board Consumer Confidence Index at 61.1 in January, it points to an unemployment rate of approximately 8% in the third quarter of this year compared to 8.3% in January this year.

Sources: I-Net; FRED; Plexus Holdings.

The valuation levels of the S&P 500, or PE10, lead the unemployment rate by approximately six months and are currently pointing to an unemployment rate of below 8% in the third quarter of this year.

I still hold the view that consumer confidence will improve to approximately 80 through end 2012 and that the valuation of the S&P 500 Index will improve to a PE10 of 25, meaning further upside of approximately 10% from the current levels. The going will be tough, though, as I think volatilities will remain high, resulting in the VIX ranging between 15 and 30 and the PE10 between 20 and 25.

Time to add the VIX to your equity portfolio? I think so.

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