Gold Isn’t Always A Hedge or Safe Haven: Gold Stock Trends Have Been Even Worse

For several years we often heard investors suggesting to “buy gold”. We could throw in Silver here, too. They provide many theories about how gold bullion or gold stocks are a “safe haven”. I’ve written about the same assumption in Why Dividend Stocks are Not Always a Safe Haven.

In fact, the Market Vectors Gold Miners ETF website specifically says about the gold stock sector:

“A sector that has historically provided a hedge against extreme volatility in the general financial markets”.

Source: http://www.vaneck.com/gdx/

When investors have expectations about an outcome, or expect some cause and effect relationship, they expose themselves in the possibility of a loss trap. I will suggest the only true “safe haven” is cash. 

Below is a 4 year chart of two gold stock ETFs relative to the Gold ETF. First, let’s examine the index ETFs we are looking at. Of course, the nice thing about ETFs in general is they are liquid (traded like a stock) and transparent (we know what they hold).

GLD: SPDR Gold “Shares offer investors an innovative, relatively cost efficient and secure way to access the gold market. SPDR Gold Shares are intended to offer investors a means of participating in the gold bullion market without the necessity of taking physical delivery of gold, and to buy and sell that interest through the trading of a security on a regulated stock exchange.”

GDX: Market Vectors Gold Miners ETF: “The investment seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of the NYSE Arca Gold Miners Index. The fund normally invests at least 80% of its total assets in securities that comprise the Gold Miners Index. The Gold Miners Index is a modified market-capitalization weighted index primarily comprised of publicly traded companies involved in the mining for gold and silver.”

GDXJ: Market Vectors Junior Gold Miners ETF seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of the Market Vectors Global Junior Gold Miners Index. The Index is intended to track the overall performance of the gold mining industry, which may include micro- and small capitalization companies.

Gold stocks vs Gold

Source: Shell Capital Management, LLC created with http://www.stockcharts.com

Clearly, gold has not been a “safe haven” or “provided a hedge against extreme volatility in the general financial markets”. It has instead demonstrated its own extreme volatility within an extreme downward price trend.

Further, gold mining stocks have significantly lagged the gold bullion index itself.

These ETFs have allowed for the trading of gold and gold stocks, SPDR Gold explains it well:

“SPDR Gold Shares represent fractional, undivided beneficial ownership interests in the Trust, the sole assets of which are gold bullion, and, from time to time, cash. SPDR Gold Shares are intended to lower a large number of the barriers preventing investors from using gold as an asset allocation and trading tool. These barriers have included the logistics of buying, storing and insuring gold.”

However, this is a reminder that markets do not always play out as expected. The expectation of a “safe haven” or “hedge against extreme volatility” is not a sure thing. Markets may end up much worst that you imagined they could.  As many global and U.S. markets have been declining, you can probably see why I think it’s important to manage, direct, limit, and control exposure to loss. Though, not everyone does it well. It isn’t a sure thing…

______

For informational and educational purposes only, not a recommendation to buy or sell and security, fund, or strategy. Past performance and does not guarantee future results. Please click the links provide for specific risk information about the ETFs mentioned. Please visit this link for important disclosures, terms, and conditions.

Uncharted Territory from the Fed Buying Stocks

I remember sometime after 2013 I told someone “The Fed is buying stocks and that’s partly why stocks have risen so surprisingly for so long”. He looked puzzled and didn’t seem to agree, or understand.

The U.S. Federal Reserve (the “Fed”) has been applying “quantitative easing” since the 2007 to 2009 “global financial crisis”. Quantitative easing (QE) is a type of monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective. The Fed implements quantitative easing by buying financial assets from banks and other financial institutions. That raises the prices of those financial assets and lowers their interest rate or yield. It also increases the amount of money available in the economy. The magnitude they’ve done this over the past seven years has never been experience before. They are in uncharted territory.

I was reminded of what I said, “the Fed is buying stocks” when I read comments from Bill Gross in “Gross: Fed Slowly Recognizing ZIRP Has Downside Consequences”. He says companies are using easy money to buy their own stock:

Low interest rates have enabled Corporate America to borrow hundreds of billions of dollars “but instead of deploying the funds into the real economy,they have used the proceeds for stock buybacks. Corporate authorizations to buy back their own stock are running at an annual rate of $1.02 trillion so far in 2015, 18 percent above 2007’s record total of $863 billion, Gross said.

You see, if we want to know the truth about market dynamics; we necessarily have to think more deeply about how markets interact. Market dynamics aren’t always simple and obvious. I said, “The Fed is buying stocks” because their actions is driving the behavior of others. By taking actions to increase money supply in the economy and keep extremely low borrowing rates, the Fed has been driving demand for stocks.

But, it isn’t just companies buying their own stock back. It’s also investors buying stocks on margin. Margin is borrowed money that is used to purchase securities. At a brokerage firm it is referred to as “buying on margin”. For example, if we have $1 million in a brokerage account, we could borrow another $1 million “on margin” and invest twice as much. We would pay interest on the “margin loan”, but those rates have been very low for years. Margin interest rates have been 1 – 2%. You can probably see the attraction. If we invested in lower risk bonds earning 5% with $1 million, we would normally earn 5%, or $50,000 annually. If we borrowed another $1 million at 2% interest and invested the full $2 million at 5%, we would earn another 3%, or $30,000. The leverage of margin increased the return to 8%, or $80,000. Of course, when the price falls, the loss is also magnified. When the interest rate goes up, it reduces the profit. But rates have stayed low for so long this has driven margin demand.

While those who have their money sitting in in bank accounts and CDs have been brutally punished by near zero interest rates for many years, aggressive investors have borrowed at those low rates to magnify their return and risk in their investments. The Fed has kept borrowing costs extremely low and that is an incentive for margin.

In the chart below, the blue line is the S&P 500 stock index. The red line is NYSE Margin Debt. You may see the correlation. You may also notice that recessions (the grey area) occur after stock market peaks and high margin debt balances. That’s the downside: margin rates are at new highs, so when stocks do fall those investors will either have to exit their stocks to reduce risk or they’ll be forced to exit due to losses. If they don’t have a predefined exit, their broker has one for them: “a margin call”.

Current Margin Debt Stock MarginSource: http://www.advisorperspectives.com/dshort/charts/markets/nyse-margin-debt.html?NYSE-margin-debt-SPX-since-1995.gif

If you noticed, I said, “They are in uncharted territory”. I am not. I am always in uncharted territory, so I never am. I believe every new moment is unique, so I believe everyone is always in uncharted territory. Because I believe that, I embrace it. I embrace uncertainty and prepare for anything that can happen. It’s like watching a great movie. It would be no fun if we knew the outcome in advance.

 

My 2 Cents on the Dollar

The U.S. Dollar ($USD) has gained about 20% in less than a year. We observe it first in the weekly below. The U.S. Dollar is a significant driver of returns of other markets. For example, when the U.S. Dollar is rising, commodities like gold, oil, and foreign currencies like the Euro are usually falling. A rising U.S. Dollar also impacts international stocks priced in U.S. Dollar. When the U.S. Dollar trends up, many international markets priced in U.S. Dollars may trend down (reflecting the exchange rate). The U.S. Dollar may be trending up in anticipation of rising interest rates.

dollar trend weekly 2015-04-23_16-04-40

Chart created by Shell Capital with: http://www.stockcharts.com

Now, let’s observe a shorter time frame- the daily chart. Here we see an impressive uptrend and since March a non-trending indecisive period. Many trend followers and global macro traders are likely “long the U.S. Dollar” by being long and short other markets like commodities, international stocks, or currencies.

dollar trend daily 2015-04-23_16-05-04

Chart created by Shell Capital with: http://www.stockcharts.com

This is a good example of understanding what drives returns and risk/reward. I consider how long the U.S. Dollar I am and how that may impact my positions if this uptrend were to reverse. It’s a good time to pay attention to it to see if it breaks back out to the upside to resume the uptrend, or if it instead breaks down to end it. Such a continuation or reversal often occurs from a point like the blue areas I highlighted above.

That’s my two cents on the Dollar…

How long are you? Do you know?

Asymmetric Nature of Losses and Loss Aversion

Loss Aversion:

“In prospect theory, loss aversion refers to the tendency for people to strongly prefer avoiding losses than acquiring gains. Some studies suggest that losses are as much as twice as psychologically powerful as gains. Loss aversion was first convincingly demonstrated by Amos Tversky and Daniel Kahneman.”

For most people, losing $100 is not the same as not winning $100. From a rational point of view are the two things the same or different?

Most economist say the two are the same. They are symmetrical. But I think that ignores some key issues.

If we have only $10 to eat on today and that’s all we have, if we lose it, we’ll be in trouble: hungry.

But if we have $10 to eat on and flip a coin in a bet and double it to $20, we may just eat a little better. We’ll still eat. The base rate: survival.

They say rationally the two are the same, but that isn’t true. They aren’t the same. The loss makes us worse off than we started and it may be totally rational to feel worse when we go backwards than we feel good about getting better off. I don’t like to go backwards, I prefer to move forward to stay the same.

Prospect Theory, which found people experience a loss more than 2 X greater than an equal gain, discovered the experience of losses are asymmetric.

Actually, the math agrees.

You see, losing 50% requires a 100% gain to get it back. Losing it all is even worse. Losses are indeed asymmetric and exponential on the downside, so it may be completely rational and logical to feel the pain of losses asymmetrically. Experience the feeling of loss aversions seems to be the reason a few of us manage investment risk and generate a smoother return stream rather than blow up.

To see what the actual application of asymmetry to portfolio management looks like, see: http://www.asymmetrymanagedaccounts.com/global-tactical/

 

asymmetry impact of loss

Diversification Alone is No Longer Sufficient to Temper Risk…

That was the lesson you learned the last time stocks became overvalued and the stock market entered into a bear market.

In a Kiplinger article by Fred W. Frailey interviewed Mohamed El-Erian, the PIMCO’s boss, (PIMCO is one of the largest mutual fund companies in the world) he says “he tells how to reduce risk and reap rewards in a fast-changing world.” This article “Shaking up the Investment Mix” was written in March 2009, which turned out the be “the low” of the global market collapse.

It is useful to revisit such writing and thoughts, especially since the U.S. stock market has since been overall rising for 5 years and 10 months. It’s one of the longest uptrends recorded and the S&P 500 stock index is well in “overvalued” territory at 27 times EPS. At the same time, bonds have also been rising in value, which could change quickly when rates eventually rise. At this stage of a trend, asset allocation investors could need a reminder. I can’t think of a better one that this:

Why are you telling investors they need to diversify differently these days?

The traditional approach to diversification, which served us very well, went like this: Adopt a diversified portfolio, be disciplined about rebalancing the asset mix, own very well-defined types of asset classes and favor the home team because the minute you invest outside the U.S., you take on additional risk. A typical mix would then be 60% stocks and 40% bonds, and most of the stocks would be part of Standard & Poor’s 500-stock index.

This approach is fatigued for several reasons. First of all, diversification alone is no longer sufficient to temper risk. In the past year, we saw virtually every asset class hammered. You need something more to manage risk well.

But, you know, they say a picture is worth a thousand words.

Since we are talking about downside risk, something that is commonly hidden when only “average returns” are presented, below is a drawdown chart. I created the drawdown chart using YCharts which uses total return data and the “% off high”. The decline you see from late 2007 to 2010 is a dradown: it’s when the investment value is under water. Think of this like a lake. You can see how the average of the data wouldn’t properly inform you of what happens in between.

First, I show PIMCO’s own allocation fund: PALCX: Allianz Global Allocation Fund. I include an actively managed asset allocation that is very large and popular with $55 billion invested in it: MALOX: BlackRock Global Allocation. Since there are many who instead believe in passive indexing and allocation, I have also included DGSIX: DFA Global Allocation 60/40 and VBINX: Vanguard Balanced Fund. As you can see, they have all done about the same thing. They declined about -30% to -40% from October 2007 to March 2009. They also declined up to -15% in 2011.

Vanguard DFA BlackRock PIMCO Asset Allcation

Charts are courtesy of http://ycharts.com/ drawn by Mike Shell

Going forward, the next bear market may be very different. Historically, investors consider bond holdings to be a buffer or an anchor to a portfolio. When stock prices fall, bonds haven’t been falling nearly as much. To be sure, I show below a “drawdown chart” for the famous actively managed bond fund PIMCO Total Return and for the passive crowd I have included the Vanguard Total Bond Market fund. Keep in mind, about 40% of the allocation of the funds above are invested in bonds. As you see, bonds dropped about -5% to -7% in the past 10 years.

PIMCO Total Return Bond Vanguard Total Bond

Charts are courtesy of http://ycharts.com/ drawn by Mike Shell

You may have noticed the end of the chart is a drop of nearly -2%. Based on the past 10 years, that’s just a minor decline. The trouble going forward is that interest rates have been in an overall downtrend for 30 years, so bond values have been rising. If you rely on bonds being a crutch, as on diversification alone, I agree with Mohamed El-Erian the Chief of the worlds largest bond manager:

“…diversification alone is no longer sufficient to temper risk. In the past year, we saw virtually every asset class hammered. You need something more to manage risk well.”

But, don’t wait until AFTER markets have fallen to believe it.

Instead, I apply active risk management and directional trend systems to a global universe of exchange traded securities (like ETFs). To see what that looks like, click: ASYMMETRY® Managed Accounts

Mike Shell Interview 2 with Michael Covel on Trend Following

As I approach the 10-year milestone of managing ASYMMETRY® Global Tactical as a separately managed account, I wanted to share my second interview with MIchael Covel on Trend Following with Michael Covel.

Many studies show that most investors, including professionals, have poor results over a full market cycle of both bull and bear markets. That necessarily means if I am creating good results, I must be believing and doing something very different than most people. In this 33 minute conversation, Michael Covel brings it out!

This is my second interview with Michael Covel, a globally famous author of several outstanding books like “Trend Following: How Great Traders Make Millions in Up or Down Markets“. I was his 4th interview when he started doing audio interviews 3 years ago and now our 2nd follow up is episode 320! For all his hard work and seeking the truth, “Trend Following with Michael Covel” is a top-ranked podcast around the world. He is in Vietnam during our interview. In 33 minutes, we describe what a true edge really is, which is how I’ve been able to create the results I have over these very challenging 10 years. And, what investors need to know today.

To listen, click: Mike Shell Interview with Michael Covel

Or, find Episode 320 in iTunes at “Trend Following with Michael Covel

For more information about my investment program, visit ASYMMETRY® Managed Accounts.

 

Mike Shell Interview 2 with Michael Covel on Trend Following Radio

Top Traders Unplugged Interview with Mike Shell: Episode 2

Top Traders Unplugged Mike Shell ASYMMETRY Global Tactical Shell Capital Management

“In the second part of our talk with Mike Shell, we delve into the specifics of his program and why most of his clients have 100% of their investments with his firm. He discusses backtesting, risk management, and the differences between purely systematic systems and systems with a discretionary element. Listen in for an inside look at this fascinating firm.” – Niels Kaastrup-Larsen

Listen: Top Traders Unplugged Interview with Mike Shell: Episode 2

 

Direct links:

Episode 2

http://toptradersunplugged.com/when-systematic-programs-arent-fully-systematic-mike-shell-shell-capital-management/

For more information, visit ASYMMETRY® Managed Accounts.

“There is always a disposition in people’s minds to think that existing conditions will be permanent …

“There is always a disposition in people’s minds to think the existing conditions will be permanent,” Dow wrote, and went on to say: “When the market is down and dull, it is hard to make people believe that this is the prelude to a period of activity and advance. When the prices are up and the country is prosperous, it is always said that while preceding booms have not lasted, there are circumstances connected with this one, which make it unlike its predecessors and give assurance of permanency. The fact pertaining to all conditions is that they will change.”  – Charles Dow, 1900

Source: Lo, Andrew W.; Hasanhodzic, Jasmina (2010-08-26). The Evolution of Technical Analysis: Financial Prediction from Babylonian Tablets to Bloomberg Terminals (Kindle Locations 1419-1423). Wiley. Kindle Edition.

You can probably see from Dow’s quote how trends do tend to continue, just because enough people think they will. However, price trends can continue into an extreme or a “bubble” just because people think they will continue forever. I like to ride a trend to the end when it bends and then be prepared to exit when it does finally reverse, or maybe reduce or hedge off some risk when the probability seems high of a change.

idowcha001p1

Image source: Wikipedia

Charles Henry Dow; November 6, 1851 – December 4, 1902) was an American journalist who co-founded Dow Jones & Company. Dow also founded The Wall Street Journal, which has become one of the most respected financial publications in the world. He also invented the Dow Jones Industrial Average as part of his research into market movements. He developed a series of principles for understanding and analyzing market behavior which later became known as Dow theory, the groundwork for technical analysis.

Asymmetrical Risk Definition and Symmetry: Do you Really Want Balance?

Asymmetric is imbalance, uneven, or not the same on both sides.

Risk is the possibility of losing something of value, or a bad outcome. The risk is the chance or potential for a loss, not the loss itself. Once we have a loss, the risk has shifted beyond a possibility to a real loss. The investment or position itself isn’t the risk either, risk is the possibility we may lose money in how we manage and deal with it.

Asymmetrical Risk, then, is the potential for gains and losses on an investment or trade are uneven.

When I speak of asymmetric risk, I may also refer to the probability for gains and losses that are imbalanced, for those of us who can determine probability. If the probability of losing something or a bad outcome is asymmetric, it means the risk isn’t the same as the reward.

Asymmetric risk can also refer to the outcome for profits and losses that are imbalanced, after we have sold a position, asset, or investment.

Some examples:

If we risk $10, but earn $10, the risk was symmetrical.

  • We risked $10
  • We earned $10 – we just broke even (symmetry).

Symmetry is the outcome when you balance risk and reward.

If we risk $10, but earn $20, the risk was positively asymmetric.

  • We risked $10
  • We earned $20

If we risk $10, but lose $10, the risk was symmetrical.

  • We risked $10
  • We lost $10 – we lost the same as we risked.

If we risk $10, but lose $20, the risk was an asymmetric risk.

  • We risked $10
  • We lost $20 – we lost even more than we though we risked.

Strangely, I often hear investment advisers say they want to balance risk and reward through their asset allocation.

Do you?

It was when I noticed my objective of imbalancing profit and loss, risk and reward, was so different from others that I knew I have a unique understanding and perception of the math and I could apply it to portfolio management.

You can probably see how some investors earn gains for years, then lose those gains in the following years, then earn gains again, then lose them again.

That’s a result of symmetry and its uncontrolled asymmetrical risk.

You can probably see why my focus is ASYMMETRY® so deeply that the word is my trademark.

Stock Market Trend: reverse back down or continuation?

I normally don’t comment here on my daily observations of very short-term directional trends, though as a fund manager I’m monitoring them every day. The current bull market in stocks is aged, it’s lasted much longer than normal, and it’s been largely driven by actions of the Fed. I can say the same for the upward trend in bond prices. As the Fed has kept interest rates low, that’s kept bond prices higher.

Some day all of that will end.

But that’s the big picture. We may be witnessing the peaking process now, but it may take months for it all to play out. The only thing for certain is that we will only know after it has happened. Until then, we can only assess the probabilities. Some of us have been, and will be, much better at identifying the trend changes early than others.

With that said, I thought I would share my observations of the very short-term directional trends in the stock market since I’ve had several inquiring about it.

First, the large company stock index, the S&P 500, is now at a point where it likely stalls for maybe a few days before it either continues to trend up or it reverses back down. In “Today Was the Kind of Panic Selling I Was Looking For” I pointed out that the magnitude of selling that day may be enough panic selling to put in at least a short-term low. In other words, prices may have fallen down enough to bring in some buying interest. As we can see in the chart below, that was the case: the day I wrote that was the low point in October so far. We’ve since seen a few positive days in the stock index.

stock index 2014-10-22_15-06-14

All charts in this article are courtesy of http://www.stockcharts.com and created by Mike Shell

Larger declines don’t trend straight down. Instead, large declines move down maybe -10%, then go up 5%, then they go down another -10%, and then back up 7%, etc. That’s what makes tactical trading very challenging and it’s what causes most tactical traders to create poor results. Only the most experienced and skilled tactical decision makers know this. Today there are many more people trying to make tactical decisions to manage risk and capture profits, so they’ll figure this out the hard way. There isn’t a perfect ON/OFF switch, it instead requires assessing the probabilities, trends, and controlling risk.

Right now, the index above is at the point, statistically, that it will either stall for maybe a few days before it either continues to trend up or it reverses back down. As it all unfolds over time, my observations and understanding of the “current trend” will evolve based on the price action. If it consolidates by moving up and down a little for a few days and then drifts back up sharply one day, it is likely to continue up and may eventually make a new high. If it reversed down sharply from here, it will likely decline to at least the price low of last week. If it does drift back to last weeks low, it will be at another big crossroads. It may reverse up again, or it may trend down. Either way, if it does decline below low of last week, I think we’ll probably see even lower prices in the weeks and months ahead.

Though I wouldn’t be surprised if the stock index does make a new high in the coming months, one of my empirical observations that I think is most concerning about the stage of the general direction of the stock market is that small company stocks are already in a downtrend. Below is a chart of the Russell 2000 Small Cap Stock Index over the same time frame as the S&P 500 Large Cap Stock Index above. Clearly, smaller companies have already made a lower low and lower highs. That’s a downtrend.

small company stocks 2014 bear market

Smaller company stocks usually lead in the early stage of bear markets. There is a basic economic explanation for why that may be. In the early stage of an economic expansion when the economy is growing strong, it makes sense that smaller companies realize it first. The new business growth probably impacts them in a more quickly and noticeable way. When things slow down, they may also be the first to notice the decline in their earnings and income. I’m not saying that economic growth is the only direct driver of price trends, it isn’t, but price trends unfold the same way. As stocks become full valued at the end of a bull market, skilled investors begin to sell them or stop investing their cash in those same stocks. Smaller companies tend to be the first. That isn’t always the case, but you can see in the chart below, it was so during the early states of the stock market peak in 2007 as prices drifted down into mid 2008. Below is a comparison of the two indexes above. The blue line is the small stock index. In October 2007, it didn’t exceed its prior high in June. Instead, it started drifting down into a series of lower lows and lower highs. It did that as the S&P 500 stock index did make a prior high.

small stocks fall first in bear market

But as you see, both indexes eventually trended down together.

As a reminder to those who may have forgotten, I drew the chart below to show how both of these indexes eventually went on to lower lows and lower highs all the way down to losses greater than -50%. I’m not suggesting that will happen again (though it could) but instead I am pointing out how these things look in the early stages of their decline.

2008 bear market

If you don’t have a real track record evidencing your own skill and experience dealing with these things, right now is a great time to get in touch. By “real”, I’m talking about an actual performance history, not a model, hypothetical, or backtest. I’m not going to be telling you how I’m trading on this website. The only people who will experience that are our investors.

 

 

VIX® gained 140%: Investors were too complacent

Several months ago I started sharing some of my observations about the VIX ( CBOE Volatility Index). The VIX had gotten to a level I considered low, which implied to me that investors were too complacent, were expecting too low future volatility, and option premiums were generally cheap. After the VIX got down to levels around 11 and 12 and then started to move up, I pointed out the VIX seemed to be changing from a downward longer term trend to a rising trend.

As I was sharing my observations of the directional trend and volatility of VIX that I believed was more likely to eventually go up than down, it seemed that most others were writing just the opposite. I know that many volatility traders mostly sell volatility (options premium), so they prefer to see it fall.

As you can see in the chart below, The VIX has increased about 140% in just a few weeks.

VIX october

Chart courtesy of http://www.stockcharts.com

For those who haven’t been following along, you may consider reading the previous observations:

A VIX Pop Then Back to Zzzzzzzz? We’ll see

Asymmetric VIX

VIX Shows Volatility Still Low, But Trending

VIX Back to Low

The VIX is Asymmetric, making its derivatives an interesting hedge

Is the VIX an indication of fear and complacency?

What does a VIX below 11 mean?

What does the VIX really represent?

The VIX, my point of view

The VIX, as I see it…

Volatility Risk Premium

Declining (Low) Volatility = Rising (High) Complacency

Investors are Complacent

 

Asymmetric VIX

In The VIX is Asymmetric, making its derivatives an interesting hedge I explained how the CBOE Volatility Index (VIX) tends to react with sharper and with greater magnitude than stock indexes. There is an asymmetric relationship between stock index returns and the VIX. Below includes yesterdays action when the S&P 500 stock index was down 2% and the CBOE Volatility Index (VIX) spot gained 27%. The chart is a good visual of how, when the stock index falls, implied volatility spikes up.

 

asymmetric vix

source: http://www.stockcharts.com

I have been sharing some observations about the VIX recently because it had gotten do a low level not seen in many years. It’s an indication that investors have become complacent about risk. When a trend gets to an extreme, it’s interesting to observe how it all plays out.

 

 

The VIX is Asymmetric, making its derivatives an interesting hedge

Asymmetric payoff VIX

The VIX is asymmetric, its distribution is non-symmetrical, it is skewed because it has very wide swings. The volatility of volatility is very volatile. There is an asymmetric relationship between stock index returns and the VIX. This asymmetric relationship is what initially makes the VIX interesting for hedging against S&P 500 volatility and losses.

Since I started the series about the extremely low VIX level Monday, like The VIX, as I see it…, The VIX has gained 17% while the S&P 500 stock index has lost about 1%. The VIX is asymmetric. While the VIX isn’t always a perfect opposite movement to the stock indexes, it most often does correlated negatively to stocks. When stocks fall, the implied (expected) volatility increases, so the VIX increases. Asymmetry is imbalance: more of one thing, less of the other. For example, more profit potential, less loss or more upside, less downside.

An advantage of the VIX for hedging is that it is asymmetric: it increases more than stocks fall. For example, when we look at historical declines in the stock index we find the VIX normally gains much more than the stock index falls. For example, if the stock index declined 5% the VIX may have gained 30% over the same period. That ratio of asymmetry of 6 times more drift would allow us to tie up less cash for a hedge position. Of course, the ratio is different each time. Sometimes it moves less, sometimes more.

When the VIX is at a low enough level as its been recently, the asymmetric nature of the VIX makes it an interesting hedge for an equity portfolio. The best way to truly hedge a portfolio is to hedge its actual holdings. That’s the only true hedge. If we make a bet against an index and that index doesn’t move like our positions, we still have the risk our positions fall and our hedge does too, or doesn’t rise to offset the loss. I always say: anything other than the price itself has the potential to stray far from the price. But the asymmetry of VIX, its potential asymmetric payoff, makes it another option if we are willing to accept it isn’t a direct hedge. And, that its derivatives don’t exactly track the VIX index, either. None of the things we deal with are a sure thing; it’s always probabilistic.

This week has been a fine example of vix asymmetry. The chart below shows it well.

 

The VIX is Asymmetric

chart source: http://www.stockcharts.com

 

Note: The VIX is an unmanaged index, not a security, so it cannot be invested in directly. We can gain exposure to the VIX through derivatives futures or options. This is not a recommendation to buy or sell VIX derivatives. To determine whether or not to take a long or short position in the VIX requires significantly more analysis than just making observations about its current level and direction. For example, we would consider the term structure and implied volatility vs. historical volatility and the risk/reward of any options combinations.

Declining (Low) Volatility = Rising (High) Complacency

When we speak of trends, we want to recognize a trend can be rising or declining, high or low. These things are subjective, because there is infinite ways to define the direction of a trend, its magnitude, speed, and absolute level. So, we can apply quantitative analysis to determine what is going on with a trend.

Below we see a quote for the CBOE Market Volatility Index (VIX). The VIX is a measure of the 30 day implied volatility of S&P 500 index options. It is a measure of how much premium options traders are paying on the 500 stocks included in the S&P 500. So, it is a measure of implied or expected volatility based on how options are priced, rather than a measure of actual historical volatility based on a past range of prices. Without going into a more detailed discussion of the many factors of VIX, I’ll add that the VIX is a fine example of an index that is clearly mean reverting. That is, the VIX oscillates between high and low ranges. Once it gets to a high level or low-level, it eventually reverts to its average. Said another way, it’s an excellent example of an index we can apply countertrend systems instead of trend following systems, because the VIX swings up and down rather than trending up or down for years.

The VIX has a long-term average of about 20 since its inception. At this moment, it is 11.82. It’s important to realize the flaw of averages here, because the VIX doesn’t actually stay around 20 – it instead averages 20 as it swings higher and lower.

VIX CBOE Market Volatility below 12

 

I used the above image from CNNMoney because it shows the rate of change in the VIX over the past 5 years on the bottom of the chart. Notice that over the past 5 years (an arbitrary time frame) market volatility as measured by VIX has declined -63.78%. To get an even better visual of the decline and price action of the VIX, below is a chart of the volatility index going back to 2001.

Do you see a trend? Do you see high and low points?

VIX Long term average high and low

We observe the current level is low by historical measures. In fact, it’s about as low at it has been. The last time the volatility index was this low was 2006 – 2007. That was just before it spiked as high as it has been during the 2007 – 2009 market crash. You can probably see what I mean by “mean reversion” and “countertrend”. When the stock market is rising, volatility gets lower and lower as investors become more complacent. Most investors actually want to get more aggressive and buy more stocks after they have already risen a lot for years, rather than realizing the higher prices go the more risky they become. We love trends, but they don’t last forever. What I think we see above is an indication that investors have become complacent, option premiums are cheap, because options traders aren’t factoring in high volatility exceptions. However, we also see that the VIX is just now down below 12.5, and area the last bull market reached in 2006 and that low volatility stayed low for over a year before it reversed sharply. Therein lies the challenge with counterrend trading: we don’t know exactly when it will reverse and trends can continue longer than we expect. And, there are meaningful shorter term oscillations of 20% or more in the VIX.

I also want to point out how actual historical volatility looks. Recall that the VIX is an index of market volatility based on how options are priced, so it implies the expected volatility over the next 30 days. When we speak of historical volatility, there are different measures to quantify the historical range prices have traded. Volatility speaks of the range of prices, so a price that averaged 100 but trades as high as 110 and low as 105 is less volatile than if it trades from 130 and 70. Below I charted the price chart of the S&P 500 since 2002. The first chart below it is ATR, which is Average True Range. ATR considers the historical high and low prices to determine the true range. A common measure is the standard deviation of historical returns. Standard deviation is charted below as STDDEV below the ATR. Below Standard Deviation is the VIX.

VIX and S&P 500 historical market volatility

Notice that the measures of volatility, both historical and implied, increase when stock prices fall and decrease when stock prices rise. Asymmetric Volatility is the phenomenon that volatility is higher in declining markets than in rising markets. You can see why I say that volatility gets lower and lower as prices move higher and higher for several years. Then, observe what happens next. Right when investors are the most complacent, the trend changes. Prices fall, volatility spikes up. They feel more sure about things after prices have been rising, so there is less indecision reflected in the range of daily trading. When investors feel more uncertain, they become indecisive, so the range of prices spread out.

Based on these empirical observations, we conclude with the title of this article.

The VIX is an unmanaged index, not a security, so it cannot be invested in directly. We can gain exposure to the VIX through derivatives futures or options. This is not a recommendation to buy or sell VIX derivatives. To determine whether or not to take a long or short position in the VIX requires significantly more analysis than just making observations about its current level and direction. For example, we would consider the term structure and implied volatility vs. historical volatility and the risk/reward of any options combinations.

 

 

 

Fact, Fiction and Momentum Investing

Fact, Fiction and Momentum Investing

Abstract

It’s been over 20 years since the academic discovery of momentum investing (Jegadeesh and Titman (1993), Asness (1994)), yet much confusion and debate remains regarding its efficacy and its use as a practical investment tool. In some cases “confusion and debate” is us attempting to be polite, as it is near impossible for informed practitioners and academics to still believe some of the myths uttered about momentum — but that impossibility is often belied by real world statements. In this article, we aim to clear up much of the confusion by documenting what we know about momentum and disproving many of the often-repeated myths. We highlight ten myths about momentum and refute them, using results from widely circulated academic papers and analysis from the simplest and best publicly available data.

Read the full paper: Fact Fiction and Momentum Investing

Source: Israel, Ronen and Frazzini, Andrea and Moskowitz, Tobias J. and Asness, Clifford S., Fact, Fiction and Momentum Investing (May 9, 2014). Can be found at SSRN: Fact, Fiction and Momentum Investing