The Russell 2000 Volatility Index (RVX) has recently fallen below the 17 percent level for the seventh time this year, and according to Citi analyst Scott Chronert, that means the Russell 2000 Index (RUT) should see a small consolidation after dropping earlier this month. He’s found that the indices are clearly negatively correlated and that investors should focus on time frames and magnitude of the correlation.

“The Russell 2000 Volatility index, RVX, has breached the 17 percent level seven times thus far during 2013, including the past week’s decline,” writes Chronert. “Subsequently, the RUT has either plateaued or sold off modestly over the ensuing 1-2 weeks. As such, a modest consolidation of the RUT’s 7 percent move off of the Oct 9 interim lows should not be unexpected.”

RVX and RUT are negatively correlated

Chronert takes it for granted that RVX and RUT are negatively correlated, and also shows that there is a strong correlation between them with a three month lag time. “Current readings are consistent with this year’s buoyant market, but also with a lesser proclivity to hedge,” he writes.

russell 200 rvx neg correlation

Russel 2000 v RVX 1013

Investors should be concerned with trends

“It’s intuitive that investors should be wary of sharp declines in volatility as there does appear to be a mean reversion aspect to shorter term trends,” he writes. Investors should be concerned mostly with the magnitude and time frame of these trends, as well as what would trigger them, but volatility risk in general is lower than it has been in the recent past. “Hedging out volatility risk to levels akin to the financial crisis and the related fallout speak more to outlier situations than has been the experience over the past couple of years,” writes Chronert.

Of course, defensives such as consumer staples and utilities have lower volatility than cyclicals like the energy sector and industrials, so volatility is sector specific because sectors with a higher beta are more exposed to market fluctuations. Also, small cap companies have continued to have higher volatility than large cap companies since 2000 (contrary to the popular notion that small cap is inherently riskier, small caps had lower volatility before that), while medium cap firms have stayed between the two extremes at least since the mid-90s.