We just closed the books on the best quarter in decades, with the Dow Jones Industrial Average surging 17% and the S&P 500 soaring 20% over the past three months.
But I’m not hearing a lot of cheering. While the numbers look great on the surface, anyone who wades out more than a few steps into the market can feel the pull of violent currents in the depths.
We’re still a long way from “normal.” Until investors find economic bedrock under their feet, Wall Street is really just treading water. Remain disciplined and respect the lifeguards.
Volatility Has Not Receded
The CBOE Volatility Index (VIX) provides a tangible demonstration of confidence. It reflects the actual prices that traders are willing to pay for option contracts, which in turn, represent a prediction of where stock prices will go.
As such, the VIX is a gauge of enlightened self-interest, as well as fear. Every time the CBOE Volatility Index ticks up or down, real money is on the line.
That’s essential. Anyone can pick a number and say that’s where the market is going. But until there’s actual skin in the game, these targets tell us less about the real world than what they reveal about the balance of fear and greed in that particular investor’s soul.
Once there’s money involved, statistical laws come into play. Under normal conditions, the VIX suggests that the S&P 500 will move between 12% and 20% in a 12-month period, or about 1-2% per month.
That’s extremely reasonable. Large stocks tend to climb roughly 11% a year, and the options market needs to make room for especially bullish years as well as the bad ones. The VIX tells the truth.
However, the VIX leapt beyond that normal range on Feb. 24 and hasn’t returned since. While we’re a long way from the extreme levels we saw in March, the index still implies that stocks will be 27% higher or lower next summer.
That’s a long way from normal, which makes perfect sense in a far from normal year of medical crisis, shock recession and, in the optimal scenario, a robust recovery.
Extreme Binary Scenarios
And the VIX at this level tells us just how far apart the bull and bear camps have gotten. When volatility is subdued, there isn’t a lot of debate over where the market is going. Now, there’s a 54% gap between the top of the implied trading range and the bottom.
It makes sense. Some of us see a return to greatness on the horizon, in which case, the S&P 500 could be trying to climb the 4,000-point wall again a year from now. That’s the positive spin on the VIX.
I make my case every week on my “Millionaire Maker” radio show. (Click here for recorded episodes and local stations.)
Others can only see the end of the world as we know it. In their world, the market still has roughly 27% left to fall. In their eyes, we will need to retrace the 2,200-point bottom before the real recovery can start.
In the short term, the market will test both scenarios. The pandemic, the economy and the political landscape will create plenty of good and bad headlines that will push stocks to extremes.
But the thing about any roller coaster is that while we visit plenty of peaks and valleys along the way, the ride ultimately ends within sight of where it started. After investors balance the highs against the lows, we’re left with a reasonable profit to reflect the hard work, innovation and sheer drive that successful stocks have on their side.
That reasonable profit varies widely from year to year but stacks up to about 11% annually for the S&P 500 as a whole. Normal volatility reflects that.
If you’re a long-term investor, that might be enough for you. Otherwise, you’ll need to take on more short-term risk to open up bigger long-term returns.
This why I track early-stage companies in my IPO Edge publication, where we go beyond the S&P 500 giants to discover stocks like Alkaline Water Co. Inc. (NASDAQ:WTER).
WTER is a tiny company today, barely 1/15,000 the size of a trillion-dollar monster like Amazon.com Inc. (NASDAQ:AMZN). But it’s rapidly becoming a top consumer brand of the post-pandemic world.
I recently took a deep dive into WTER’s prospects and liked what I saw. You can see my conclusions for yourself. Click here to download the report.
Let’s just say that I’m not surprised to see the stock up 24% year to date. And it has a long way to go before it’s even big enough to join my “normal” high-growth portfolio in GameChangers.
CANNABIS CORNER: SMALL IS BEAUTIFUL
While we’ve talked a lot about a few of the biggest cannabis stocks, the real high-impact opportunities are off the beaten track. This week, Hexo Corp. (NYSE:HEXO) has proven that with a 7% rebound.
Granted, HEXO has a lot of heavy lifting to do down here at $0.76 to catch up with the giants. It has been a grim year for the industry, and this stock is down a harrowing 86% in the last 12 months.
But in the grand scheme of things, that performance isn’t much worse than what the giants have suffered. Tilray Inc. (NASDAQ:TLRY) is down 85% over the same period. Aurora Cannabis Inc. (NYSE:ACB) is down 86% as well.
When the pain is equally shared, the odds favor the disruptive little company over the entrenched leader. It’s just math: a small stock can double and redouble on progress that wouldn’t even budge a giant.
The potential returns simply stack up higher the lower you look. That’s why I have been a fan of tiny and obscure names, like Pharmacielo Ltd. (OTCMKTS:PCLOF), for the long win here.
After all, when giants fall as hard as upstarts, the risk profile is equalized. You need to look to the returns instead.
Of course, you might not want to get involved with recreational cannabis at all. In that case, Aphria Inc. (NASDAQ:APHA) has matched little HEXO point for point this week.
And unlike HEXO and the giants, the downside on APHA’s medicinal business has been substantially easier. This stock is down only 37% in the last year, which is a whole lot easier to recover when the bulls are back in control.
Join me at the MoneyShow in Las Vegas on Tuesday, Aug. 16, for my special presentation Building Wealth with Stocks and the Master Class Value Investing with a Growth-&-Income Twist. Register at Kramer.MoneyShow.com. The event will take place at Bally’s and the Paris right on the Strip. I hope to see you there!