The "fiscal cliff" might be political theatre, but whatever the outcome, a rising CBOE Volatility Index signals bad news ahead for investors in Canadian small cap stocks.
Often called the Fear Index, the CBOE Volatility Index (VIX) uses option prices to predict the future course of equity markets. When the VIX is the rising, it indicates that companies selling options are charging higher prices because they expect major equity market moves in the near future. Since the beginning of December, the VIX index has moved almost 30 per cent higher as investor anxiety intensifies ahead of the "fiscal cliff" deadline.
Canadian small cap stocks, as measured by the MSCI Canadian Small Companies Index, have historically moved in the opposite direction of the VIX. Small caps stocks are more volatile than their larger counterparts and more sensitive to changes in market risk tolerance. When a rising VIX signals increasing fear among investors, domestic small company stocks head lower.
The VIX often leads the small cap index, providing an important early warning for investors. As this chart shows (note that the VIX data is plotted inversely to better show the trend), the VIX successfully predicted a market bottom for Canadian small cap stocks in both September 2001 and May 2012.
The recent upward move in the VIX is not yet big enough to provide a clear sell signal for small cap investors. But with political leaders from both U.S. parties admitting that avoiding the fiscal cliff appears unlikely, investors should pay close attention to the VIX, lightening up on small caps as it climbs higher.
Scott Barlow