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VIX picks: Stocks to buy when volatility returns

One of these days, anxiety is going to return to the stock market. And when it does, it's safe to assume that today's high-flying stocks are not going to benefit from the shift. But what will?

Savita Subramanian, equity and quant strategist at Bank of America, set out to answer that question – and her search arose from a belief that today's calm market probably won't last.

The CBOE Volatility index, or VIX, is one of the most popular gauges of market sentiment, and it has been coasting along five-year lows for most of the past month. The index, which reflects expectations of volatility in the S&P 500 over the next 30 days, has been suggesting that fear is on vacation right now.

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The VIX rose slightly to 14.8 on Monday, but any level below 16 is considered very low by historical standards. And it has been prone to sudden spikes in recent years: It hit 48 in August 2011, 46 in May 2010 and jumped above 80 during the scariest phase of the financial crisis in November 2008.

While Ms. Subramanian isn't forecasting a similarly dramatic spike into the stratosphere, she does believe that the index will likely move higher by the end of the year.

"The cycles of the VIX over time suggest that the likelier direction over the next 12 months is up rather than down," she said in a note. "Historically, when the VIX has been as low or lower than it is today, it has increased over the next 12 months about two out of three times, by about 20 per cent on average."

Her reasoning comes from a few sources. She sees limited upside reward to the S&P 500, given the benchmark index's valuation. But the downside risks are growing, largely because analysts are busily cutting their earnings expectations.

As well, investor sentiment could be easily rattled by big-picture issues, including Middle East tensions, the European sovereign-debt crisis and the impact of the U.S. "fiscal cliff" of higher taxes and lower government spending.

And on a more technical note, she believes there is a relationship between the slope of the yield curve (or the difference between the yield on 2-year and 10-year U.S. government bonds) and the VIX index. That is, the shrinking difference in bond yields could be pointing to stock market volatility ahead.

"Although some argue that yield curve has been manipulated by rounds of QE or is flattening for non-fundamental reasons, we have heard similar skepticism about the yield curve's relevance in prior cycles, yet it has accurately forecast rising volatility in these instances," she said.

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If the VIX does rise, there is likely to be a shift among investor preferences to coincide with an increase in anxiety. On a sector basis within the S&P 500, that means that some defensive areas of the market should outperform, while economically sensitive areas of the market will struggle.

For data going back to 1990, Ms. Subramanian found that consumer staples and health care stocks have done the best when the VIX is rising, while financials and consumer discretionary stocks have done the worst. Energy stocks are one exception: They tend to do okay when the VIX is moving higher.

"Rising volatility typically indicates heightened risk aversion – in these environments, investors may become less price sensitive and more inclined to pay for stable earnings growth," she said.

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