The old Warren Buffett maxim of being greedy when others are fearful requires some measure of fear in order to know when to be greedy. As I discussed in my last column on How to read fear in the stock market, we have a fear index that is based on the amount of excess volatility – or irrational volatility.
This chart shows the last 12 months of the fear index, known as the VIX, up to the close of Tuesday 22 May.
Chart 1: The Fear Index
The two dotted lines mark a range where the fear index resided much of the time before the onset of the global financial crisis (GFC) – 68% of the time in fact. Thus, fear is unusual when the index spends a lot of time above or below the dotted lines for more than 16% of the time (since the time spent outside the range before the GFC is: 100% – 68% = 32% ÷ 2 = 16%, that is 16% above and 16% below the range). Too low and investors might be getting complacent; too high and investors may be more likely to overreact to bad news.
Unfortunately, last week produced a great case study. When it became clear that the Greeks were going to have to go to the polls again in mid June, the uncertainty led markets sharply lower – about 5.6% down for the week on the S&P/ASX200 – and that took away all of the gains for the year. However, fear hardly budged, just peeking above the upper line on Monday when the market went up!
If we turn to ‘ordinary’ market volatility for the same period in Chart 2, we can see that it got well above the upper dotted line, which in this chart represents the average volatility during the GFC. The lower dotted line is the average before the GFC and the solid line is the average volatility since the GFC.
Although it is hard to be confident when volatility is high, our research shows that normal fear coupled with the underpricing we have in many sectors (see woodhall.com.au) presents possible buying opportunities at a good discount. Of course, it would be foolish just to dive in headfirst but making some trades spaced apart by a few days might give investors a reasonable average price.
Chart 2: Market volatility
With China being committed to stimulating its economy and Europe starting to lean towards a less harsh stance on austerity, the medium term looks a lot brighter than it did last Friday! There are plenty of blue chip stocks that have taken a big hit: BHP, RIO, CBA, WBC and many more. And as of the time of writing (Tuesday 22 May) the bounce back has so far been small.
What I’ve been doing
I sold all of my Sonic Healthcare in my super fund on May 10 at a slight (untaxable) capital gain of about 10% over about a three-year period with a dividend yield of about 5% (partially franked) – not great, but it charged up from $11.28 at the start of the year and my earnings were better than cash over the holding period. I made that sale because the Health sector was overpriced by 6% and, therefore, I thought it less likely to make strong gains in the near future. I just put the proceeds back in the market today with a buy on RIO at $56.80. We have that sector underpriced by nearly 20%!
At the time of writing, Sonic is up a fraction from my sale of it 12 days ago (now $12.77), but RIO is down about 9% over the same period. RIO was $60.30 at the start of the year and climbed to $72.30 in February. I have been waiting for more than six months for an opportunity like this to arise to get my RIO exposure to where I wanted it. Clearly I am backing the China story. I am slowly getting out of my defensive stocks and into growth – hopefully before everybody else does!
Ron Bewley if the executive director of Woodhall Investment Research Pty Ltd.
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