Two Contrarian Sector Trades

Every Friday evening I watch a show called Ancient Aliens with my 91-year-old mother. She likes it for the visuals; every episode has detailed images of hundreds of archaeological sites she has visited in her life. I majored in Near Eastern Archaeology, so I like to see how the show inserts a wild premise – that aliens visited ancient civilizations – into the distinctly non-alien framework I learned in school.

Since my thoughts always wander back to financial markets, I often ponder what the CBOE VIX Index would do if aliens suddenly appeared among us. It is a useful thought exercise regarding the market’s ability to price profound uncertainty. My guess is that all financial assets would take a beating, and the VIX would either go to 1000 or zero. The first outcome would occur if the aliens seemed friendly. If they were not, the VIX would go to zero because for the first time in human history, there would be no uncertainty. But not in a good way…

That’s the funny thing about the VIX and similar options-related measures of risk. While they measure the market’s take on future price risk, they are deeply anchored in the recent past. There is no “alien invasion” premium in put/call prices. Rather, options prices try to predict how much the next few months will resemble the previous couple of weeks.

In that vein, consider what has happened to the pricing of implied volatility (IV, essentially what the VIX Index measures) for listed options tied to the US large cap Technology and Energy sectors. Four quick points here:

  • For most sectors of the S&P 500, February/March’s volatility storm was also the high point for their “VIX” in 2018 to date.
  • Two sectors – Industrials and Financials – saw their 2018 peak “VIX” in October, just as the market slide started. That makes sense, as trade war and Fed policy concerns hit those groups the hardest.
  • More recently, Tech hit its 52-week “VIX peak” on November 20th. Yes, as bad as February/March was for market volatility, this sector saw the highpoint for price uncertainty just a few weeks ago.
  • And just a few days ago, on December 4th, large cap Energy hit its “VIX peak” for the year.

What this means for near term market and sector direction:

  • The VIX is commonly thought of as a contrary indicator – when it spikes, you buy equities.
  • While the CBOE VIX index is nowhere near its 2018 high, one important sector (Technology, 20.1% of the index) has recently broken through to new highs for its “VIX”. That alone is not enough to call a bottom in the S&P, however, since we would want to see similar panic in other large groups like Health Care.
  • Energy, while not as important to the S&P 500 (5.5% weighting), is sitting at higher VIX levels than its February/March levels right now. That might signal the beginning of a bottoming process for oil prices, the proximate cause for the sector’s recent stress.

Key takeaway: it takes a profoundly contrarian and (more importantly) patient nature to buy the S&P 500 when the VIX is soaring, and the same holds true for using Implied Volatility levels to buy beaten-up sectors. The first half of 2018 tells that story well enough, because stocks churned for several months after the VIX spiked in February. But if that’s a strategy you like, this work gives you two ideas to look at: large cap Tech and Energy.