Historic day for the stock market

Today was just a reversal of Friday’s late-day surge.

SPX SPY TRADING

The stock market is even more washed out.

With the Federal Reserve lowering interest rates and buying back bonds, the long term US Treasury Index reversed back up.

long term treasuries

The stock indexes are down to their 2018 lows and if the selling doesn’t dry up, we may see a mean reversion of the last 10 years. It wouldn’t be surprising for many reasons, especially when we see it happens to be the area of trouble in 2015-16. Keep in mind, the Fed has been a key return driver for the last several years. It doesn’t seem to be working anymore.

spx mean reversion

I’m a risk manager, risk-taker, so I increase and decrease exposure to asymmetric risk/reward as conditions change over time. When I see signs of the selling pressure drying up or buying enthusiasm overwhelming the selling pressure, I’ll be looking to buy stocks again.

That is all.

Let me know if we can help.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global TacticalMike Shell and Shell Capital Management, LLC is a registered investment advisor in Florida, Tennessee, and Texas. Shell Capital is focused on asymmetric risk-reward and absolute return strategies and provides investment advice and portfolio management only to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. I observe the charts and graphs to visually see what is going on with price trends and volatility, it is not intended to be used in making any determination as to when to buy or sell any security, or which security to buy or sell. Instead, these are observations of the data as a visual representation of what is going on with the trend and its volatility for situational awareness. I do not necessarily make any buy or sell decisions based on it. Any opinions expressed may change as subsequent conditions change.  Do not make any investment decisions based on such information as it is subject to change. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. The views and opinions expressed in ASYMMETRY® Observations are those of the authors and do not necessarily reflect a position of  Shell Capital Management, LLC. The use of this website is subject to its terms and conditions.

Profiting from the Madness of Crowds

If we want to profit from the madness of crowds, we necessarily need to believe and do different things than the crowd at the extremes.

You may have heard the stock market was down a lot yesterday. I consider yesterday’s price action a black swan event.  The -8% one-day decline was the worst day for S&P500 since 2008 and the 19th worst day since 1928.

The popular S&P 500 stock index dropped -7.6%, which was enough to trigger a circuit breaker to halt trading for the first time in 23 years. Circuit breakers are the thresholds when, if reached during a single-day decline in the S&P 500, trading is halted. Circuit breakers halt trading on US stock markets during dramatic price declines and are set at 7%, 13%, and 20% of the closing price for the previous day.

After yesterday’s waterfall decline, the price trend of the S&P 500 lost the 24% gain it had achieved a month ago.

stock market lost 2020 gain

Interestingly, we’re seeing “mean reversion” as the SPX is now all the way back to the same level it reached in January 2018. In investment management, mean reversion is the theory that a stock’s price will tend to move to the average price over time. This time it did.

mean reversion SPX SPY S&P 500

US equity investors would have been better off believing the market was too overvalued then and shifting to short term Treasuries. But, who would have been able to do that? Who wouldn’t have had the urge to jump back in on some of the enormous up days the past two years? There’s the real challenge: investor behavior. And yes, some may even look back and say they knew then but didn’t do anything. If we believed it then, we can go back and read out notes we made at the time. But, it wouldn’t matter if a belief isn’t acted on. I’m a trigger puller, I pull the trigger and do what I believe I should do in pursuit of asymmetric risk/reward for asymmetry.

Dow Jones is down -16.4% YTD at this point.

dow jones 2020 loss

The Dow Jones has also experienced some “mean reversion” over the 3-year time frame.

dow jones 2020 loss bear stock market

Mid-cap stocks, as measured by the S&P 400, are down, even more, this year, in the bear market territory.

mid cap stock in bear market MDY

Small-cap stocks, considered even riskier, are now down -23% in 2020.

small cap stocks are in a bear market

Clearly, the speed and magnitude of this waterfall decline have been impressive since the February 19th top just three weeks ago. Decreases in these broad stock indexes of -20% are indications of a strong desire to sell and yesterday, panic selling.

So, -20% from peak, the stock market decline has reached bear market territory and is now nearly in-line with the typical market-sell off since 1928 that preceded an upcoming recession.

Global Equity Market Decline

And by the way, it wasn’t just US equities, the selling pressure was global with some markets like Russia, Australia, Germany, Italy, and Brazil down much more.

stock stock market selloff

Extreme Investors Fear is Driving the Stock Market 

Indeed, after Extreme Fear is driving the stock market according to investor sentiment measures. A simple gauge anyone can use is the Fear & Greed Index, which measures seven different indicators.

As of today, it shows the appetite for risk is dialed back about as close to zero it can get.

what is driving the stock market

In the next chart, we can observe the relative level of the gauge to see where it is comparable to the past. While this extreme level of fear can stay elevated for some time, it has now reached the lowest levels of 2018. It’s important to note this isn’t a market timing indicator, and it does not always provide a timely signal. As you can see, at prior extreme lows such as this, the fear remained extreme for some time as the indicator oscillated around for a while. It’s a process, not an event. Investor sentiment measures like this tell us investors are about as scared as they get at their extreme level of fear is an indication those who wanted to sell may have sold.

fear greed investor sentment over time

Monitoring Market Conditions

My objective is asymmetric investment returns, so I look to find an asymmetric risk-reward in a new position. An asymmetric return profile is created by a portfolio of asymmetric risk-reward payoffs. For me, these asymmetric payoffs are about low-risk entries created through predefined exits and how I size the positions at the portfolio level. As such, I’ve been entering what I consider to be lower risk points when I believe there is potentila for an asymmetric payoff. Sometimes these positions are entering a trend that is already underway and showing momentum. The market is right most of the time, but they get it wrong at extremes on both ends. I saw that because of my own personal observations for more than two decades of professional money management, which is confirmed, markets and behavior really haven’t changed.

Humphrey B. Neill, the legendary contrarian whose book “The Art of Contrary Thinking,” published in 1954, including the same observations nearly seventy years ago.

“The public is right more of the time than not ” … but “the crowd is right during the trends but wrong at both ends.”

As market trends reverse and develop, we see a lot of indecision about if it will keep falling or reverse back up, which results in volatility as prices spread out wider driven by this indecisiveness. Eventually, the crowd gets settled on once side and drives the price to trend more in one direction as the majority of capital shifts enough demand to overwhelm the other side.

Risk Manager, Risk Taker

At these extremes, I have the flexibility to shift from a trend following strategy to a  countertrend contrarian investment strategy. My ability to change along with conditions is why I am considered an “unconstrained” investment manager. I have the flexibility to go anywhere, do anything, within exchange-traded securities. By “go anywhere,” I mean cash, bonds, stocks, commodities, and alternatives like volatility, shorting/inverse, real estate, energy MLPs, etc. I give myself as broad of an opportunity set as possible to find potentially profitable price trends. So, as prices have been falling so sharply to extremes, I was entering new positions aiming for asymmetric risk/reward. I was able to buy at lower prices because I had also reduced exposure at prior higher prices. As trends became oversold as measured by my systems, I started increasing exposure for a potential countertrend.

On ASYMMETRY® Observations, I’m writing for a broad audience. Most of our clients read these observations as do many other investment managers. My objective isn’t to express any detail about my specific buying and selling, but instead overall observations of market conditions to help you see the bigger picture as I do. As long time readers know, I mostly use the S&P 500 stock index for illustration, even though I primarily trade sectors, stocks, countries; an unconstrained list of global markets. I also share my observations on volatility, mostly using the VIX index to demonstrate volatility expansions/contractions. At the extremes, I focus a lot of my observations on extremes in investor sentiment and breadth indicators to get an idea of buying and selling pressure that may be drying up.

Market Risk Measurement 

One of my favorite indicators to understand what is going on inside the stock market is breadth. To me, breadth indicators are an overall market risk measurement system. Here on ASYMMETRY® Observations, I try to show these indicators as simple as possible so that anyone can understand.

If we want to profit from the madness of crowds, we necessarily need to believe and do different things than the group at the extremes.

One of my favorite charts to show how the market has de-risked or dialed up risk is the percent of S&P 500 stocks above the moving average. As you see in the chart, I labeled the high range with red to signal a “higher risk” zone and the lower level in green to indicate the “lower risk” zone.

percent of s&P stocks above moving average 2020

I consider these extremes “risk” levels because it suggests to me after most of the stocks are already in long term uptrends, the buying enthusiasm may be nearing its cycle peak. And yes, it does cycle up and down, as evidenced by the chart. As of yesterday’s close, only 17% of the S&P 500 stocks are trending above their 200-day moving average, so most stocks are in a downtrend. That’s not good until it reaches an extreme level, then it suggests we may be able to profit from the madness of crowds as they tend to overreact at extremes.  The percent of S&P 500 stocks above the longer-term moving average has now declined into the green zone seen in late 2018, the 2015-16 period, 2011, but not as radical as 2008 into 2009. If this is the early stage of a big bear market, we can expect to see it look more like the 2008-09 period.

We can’t expect to ever know if equities will enter a bear market in advance. If you base your trading and investment decisions on the need to predict what’s going to happen next, you already have a failed system. You are never going to know. What I do, instead, is focus on the likelihood. More importantly, I predefined the amount of risk I’m willing to take and let it rip when the odds seem in my favor. After that, I let it all unfold. I know I’ll exit if it falls to X, and my dynamic risk management system updates this exit as the price moves up to eventually take profits.

Zooming in to the shorter trend, the percent of stocks above their 50 day moving average has fallen all the way down to only 5% in an uptrend. This means 95% of the S&P 500 stocks are in shorter-term downtrends. We can interpret is as nearly everyone who wants to sell in the short term may have already sold.

stock market breadth risk management market timing

I can always get worse. There is no magical barrier at this extreme level that prevents it from going to zero stocks in an uptrend and staying there a long time as prices fall much more. But, as you see in the charts, market breadth cycles up and down as prices trend up and down.

If we are in the early stage of a big bear market, I expect there will be countertrends along the way if history is a guide. I’ve tactically traded through bear markets before, and the highlight of my career was my performance through the 2007-09 period. I didn’t just exit the stock market and sit there, I traded the short term price trends up and down. If someone just exited the stock market and sit there, that may have been luck. If we entered and exited 8 or 10 different times throughout the period with a positive asymmetry of more significant profits than losses, it may have required more skill. I like my managed portfolio to be in synch with the current risk/reward characteristics of the market. If that is what we are achieving, we may have less (or hedged) exposure at the peak and more exposure after prices fall. I believe we should always be aware of the potential risk/reward the market itself is providing, and our investment strategy should dynamically adapt to meet these conditions.

If we want to profit from the madness of crowds, it means we have some cash or the equivalent near trend highs and reenter after prices fall. It may also be achieved by hedging near highs and using profits from the hedge to increase exposure after prices have dropped. It sounds like a contrarian investor. To be a contrarian investor at extremes to profit from a countertrend, we study crowd behavior in the stock market and aim to benefit from conditions where other investors/traders act on their emotions. These extremes of fear and greed are seen at major market turning points, presenting the disciplined contrarian with opportunities to both enter and exit the market.

This crowd psychology has been observed for many decades, and unfortunately, investors and traders are excellent lab rates to study the behavior.

Believe it or not, 179 years ago, in 1841, Charles Mackay published his book “Extraordinary Popular Delusions and the Madness of Crowds” in which discussing the South Sea Bubble and Dutch Tulip Mania as examples of this mass investment hysteria. People haven’t changed. As a crowd, we the people still underreact to initial information and then overreact at the extremes.

As Mackay observed nearly two centuries ago:

“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.”

Once people begin to go with the crowd, their thinking can become irrational and driven by the emotional impulses of the crowd rather than on their own individual situation.

According to studies like DALBAR’s Quantitative Analysis of Investor Behavior (QAIB), individual investors have poor results over the long haul. QAIB has measured the effects of investor decisions to buy, sell and switch into and out of mutual funds over short and long-term timeframes since 1994 and finds people tend to do the wrong things at the wrong time. If we want to create different results from the majority, we must necessarily believe and do things differently.

At this point, we’ve seen fund flows from stocks to bonds reach extreme levels across multiple time frames as panic selling set in. I’m glad to say, while imperfect as to timing, I have done the opposite by shifting to short term US Treasuries at the prior high stock prices and then started rebuying stocks last week. Of course, I have predetermined points I’ll exit them if they fall, so I remain flexible and may change direction quickly, at any time.

I’m seeing a lot of studies showing that history suggests single-day waterfall declines like yesterday were followed by gains over the next few weeks. Rather than hoping past performance like that simply repeats, I prefer to measure the current risk level and factor in existing conditions.

It’s important to understand, as. I have pointed out many times before, that the US stock market has been in a very aged bull market that has been running 11 years now. And the longest on record. The US is also in the longest economic expansion in history, so we should be aware these trends will eventually change. But, when it comes to the stock market, longer trends are a process, not an event. Longer trends unfold as many smaller swings up and down along the way that may offer the potential for flexible tactical traders to find some asymmetry from the asymmetric risk/reward payoffs these conditions may create.

It’s also important to be aware the volatility expansion and waterfall decline the past three weeks seems to indicate a fragile market structure with a higher range of prices, so we’re likely to observe turbulence for some time. These conditions can result in amplified downtrends and uptrends.

Falling prices create forced selling by systematic investment managers similar to what we saw in the December 2018 market crash. As I’ve seen signals from my own systematic trend following and momentum systems shift, it’s no surprise to see some increased selling pressure that may be helped by more money in these programs.

We are in another period of extremes driven by the “madness of crowds,” and my plan is to apply my skills and experience with the discipline to tactically operate through whatever unfolds.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global TacticalMike Shell and Shell Capital Management, LLC is a registered investment advisor in Florida, Tennessee, and Texas. Shell Capital is focused on asymmetric risk-reward and absolute return strategies and provides investment advice and portfolio management only to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. I observe the charts and graphs to visually see what is going on with price trends and volatility, it is not intended to be used in making any determination as to when to buy or sell any security, or which security to buy or sell. Instead, these are observations of the data as a visual representation of what is going on with the trend and its volatility for situational awareness. I do not necessarily make any buy or sell decisions based on it. Any opinions expressed may change as subsequent conditions change.  Do not make any investment decisions based on such information as it is subject to change. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. The views and opinions expressed in ASYMMETRY® Observations are those of the authors and do not necessarily reflect a position of  Shell Capital Management, LLC. The use of this website is subject to its terms and conditions.

 

 

 

Dow Jones is down -10% off its high

Dow Jones is down -10% off its high. I don’t pay much attention to the Dow Jones Industrial Average as it’s a price-weighted index of 30 stocks. But, the S&P 500 capitalization-weighted index of approximately 500 stocks seems a better proxy for “the market,” and it’s not far behind.

Here is the percent off high (drawdown) chart year to date.

dow jones down over 10 %

We don’t own either of these ETFs, they are for illustration only. In fact, our portfolio is was 85% U.S. Treasuries, and 15% invested in high dividend-yielding positions. One of them has a dividend yield of 9.8% and the other 11.9%, so while their prices may be falling with the stock market, we have some margin of safety from the high yield. In fact, as the prices fall, the yield rises from that starting point.

Speaking of dividend yield below is a visual of the dividend yield of the S&P 500 (1.84’%) and the Dow (2.27%), which are relatively low historically. But, as prices fall, the yields will rise, assuming the stocks in the index keep paying dividends.

stock dividend yield

In the above chart, I’m using the ETF dividend yields as they are real-time. Since the ETFs have only been trading for two or three decades, to see what I mean by “long term” I look at the S&P 500 Stock Index dividend yield (calculated as 12-month dividend per share)/price) to see how low the yield has been the past twenty years.

long term stock dividend yield

So, the future expected return from dividend yields on these stocks indexes is relatively low, looking back 150 years. The spikes you see are after stock market crashes as the price falls, the yield rises, as with bonds. Low dividend yield also suggests the stock market is overvalued. A higher dividend yield indicates the stock market is undervalued, and if nothing else, investors earn a higher income from the dividends from a lower starting price.

Back to the year to date, the short term, the S&P 500 is now down -5% in 2020, and the Dow Jones is down -7%.

stock market drop 2020

I believe this may be the fastest -10% decline in the history of the Dow Jones Industrial average.

I’m just glad we aren’t in it.

This is when drawdown controls and risk management pays. More importantly, it’s when discipline pays as some investment managers intend to manage risk to limit their drawdowns; they don’t excel in doing it. Discipline is a personal edge. It doesn’t matter how good our scientifically tested quantitative models and systems with a mathematical basis for believing in them if we lack the discipline to execute them with precision. But, I can go on to say that it isn’t enough for me to have all the discipline either, as we much necessarily help our investment management clients stick with it, too. So, investor behavior modification is part of our wealth management services. It’s why Christi Shell is not only a Certified Wealth Strategist® with over twenty-six years of experience helping high net worth families with the overall management of assets but also a certified Behavioral Financial Advisor® (BFA®) to help them manage themselves.

It’s what we do.

Need help? Contact us here.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global TacticalMike Shell and Shell Capital Management, LLC is a registered investment advisor in Florida, Tennessee, and Texas focused on asymmetric risk-reward and absolute return strategies and provides investment advice and portfolio management only to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. I observe the charts and graphs to visually see what is going on with price trends and volatility, it is not intended to be used in making any determination as to when to buy or sell any security, or which security to buy or sell. Instead, these are observations of the data as a visual representation of what is going on with the trend and its volatility for situational awareness. I do not necessarily make any buy or sell decisions based on it. Any opinions expressed may change as subsequent conditions change.  Do not make any investment decisions based on such information as it is subject to change. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. The views and opinions expressed in ASYMMETRY® Observations are those of the authors and do not necessarily reflect a position of  Shell Capital Management, LLC. The use of this website is subject to its terms and conditions.

Employment, Coronavirus, it’s just the market, doing what it does…

It seems most people probably believe the news drives the stock market.

I can see why, since the news headlines want to tell a story.

We like a great story. We want to hear the narrative. We definitely want to believe we know the causation of things going on around us.

Do you believe the news drives stock price trends?

Coronavirus Live Updates: Trump Praises China’s Response to Outbreak as Death Toll Passes 600 – New York Times 

The Coronavirus outbreak in Wuhan China has grown exponentially as asymmetric uncertainties usually do. According to Worldometer, there are now 31,535 of which 4,826 (15%) in critical condition 638 deaths and 1,778 have recovered. 
number of Coronavirus Cases
The Coronavirus outbreak only started less than a month ago, but its rate is exponential.
coronavirus total cases deaths
This is not the kind of asymmetry we want to observe. I hope a cure is found soon to save these human lives.
How has the stock market reacted?

The S&P 500 gained over 3% the past 5 days anyway… 

spy spx trend following etf

It’s just the market… doing what it does…

This morning, in the U.S. we get great news on employment data.

The US Unemployment Rate measures the percentage of total employees in the United States that are a part of the labor force but are without a job. It’s one of the most widely followed indicators of the health of the US labor market and the US economy as a whole. Historically, the US Unemployment Rate reached as high as 10.80% in 1982 during a notable recessionary period.

The low Unemployment Rate has been a bright spot for the U.S. economy since unemployment trended up sharply in 2008 and peaked at 10.10% in November 2009, the highest level since ’82. A picture is worth a thousand words, so here the trend. from January 2007 to November 2009 as Unemployment Rate increased sharply from 4.4% to 10.10% in about two years.

us unemployment peak 2008 2009

Looking at the US Unemployment Rate in the bigger picture, below are the trends and cycles going back over sixty years. US Unemployment Rate is at 3.60%, compared to 3.50% last month and 4.00% last year. This is lower than the long term average of 5.73%. The last recession was the second-highest unemployment and it has recovered even smoother than before.

US UNEMPLOYMENT RATE

The headlines today:

January adds a much stronger-than-expected 225,000 jobs, with a boost from warm weather” – CNBC

The stock indexes are down over -0.50% anyway…

I say: It’s just the market, doing what it does… 

I believe investors underreact and overreact to new information “news.”

An overreaction is when price trends become overbought or oversold driven by psychological and investor sentiment reasons rather than fundamentals. It’s why we see crashes and bubbles, over short term and long term periods.

An underreaction is when investors initially underreact to new information such as earnings announcements, which leads to a predictable price drift. In other words, underreaction drives price trends!

Prices drift up or down over time when investors underreact to information.

Prices overshoot, trade up or down too far, too fast, when investors overreact to information.

This why my focus is on the direction of price trends, along with volatility, investor sentiment, and multiple time frame momentum.

My directional trend following systems are designed to catch the trends that drift from underreaction.

My countertrend systems signaled by momentum, extreme investor sentiment, and volatility analysis, are engineered to capitalize on overreactions.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global TacticalMike Shell and Shell Capital Management, LLC is a registered investment advisor in Florida, Tennessee, and Texas focused on asymmetric risk-reward and absolute return strategies and provides investment advice and portfolio management only to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. Any opinions expressed may change as subsequent conditions change.  Do not make any investment decisions based on such information as it is subject to change. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. The views and opinions expressed in ASYMMETRY® Observations are those of the authors and do not necessarily reflect a position of  Shell Capital Management, LLC. The use of this website is subject to its terms and conditions.

 

 

19 is the new 20, but is this a new low volatility regime?

We used to say the long term average for the Cboe Volatility Index VIX is 20.

Some would mistakenly say that VIX “reverts to the mean”, suggesting it is drawn to the average level of 20, which isn’t exactly the condition. It doesn’t cycle up and down to trend around 20 most of the time, but instead, it spends much of the time between 10 and 30.

Prior to 2015, the long term average of VIX since its inception was 20 and we heard the number 20 referenced with VIX often. ^VIX Chart

Since January 2015, we’ve seen the long term average decline to the 19 levels.  ^VIX Chart

So, 19 is the new 20.

What caused the downtrend in the long term average?

Obviously, it would take a very low level of readings to drive down the long term average of a volatility index introduced in 1993.

What happened in the past 5 years that impacted the prior 21 years of data so much to bring the 26-year average down?

A 5 year period of low implied volatility happened with an average of 15% and a low of 9.14%. Said another way; the past 5 years expected volatility priced into S&P 500 stock options has been about 25% lower than the prior two decades, or 75% of what we previously observed. Here is the trend for VIX from 2015 to today. A VIX level of 15 translates to implied volatility of 15% on the S&P 500. 
^VIX Chart

Is this a new low volatility regime?

Anything is possible, but I’m guessing the lower level of implied (expected) volatility may be driven by two facts that can both result in less concern for volatility.

  1. The current bull market that started in March 2009 is the longest bull market in history. It exceeded the bull market of the 1990s that lasted 113 months in terms of time, though still not as much gain as the 90s.
  2. The U.S. is in its longest economic expansion in history, breaking the record of 120 months of economic growth from March 1991 to March 2001, according to the National Bureau of Economic Research. However, this record-setting run observed GDP growth far slower than previous expansions.

The aged bull market and economic expansion can naturally lead to some level of complacency and expectation for less downside and tighter price trends. When investors are uncertain, their indecision shows up in a wide range of prices. When investors are smugger and confident, they are less indecisive and it’s usually after a smooth uptrend they expect to continue.

Is it another regime of irrational exuberance?

“Irrational exuberance” was the expression used by the former Federal Reserve Board chairman, Alan Greenspan, in a speech given during the dot-com bubble of the 1990s. The expression was interpreted as a warning that the stock market may have been overvalued. It was.

Irrational exuberance suggests investor enthusiasm drives asset prices up to levels that aren’t supported by fundamental financial conditions. The 90s ended with a Shiller PE Ratio over 40, far more than any other time in more than a century.

Is the stock market at a level of irrational exuberance?

Maybe so, as this is the second-highest valuation in the past 150 years according to the Shiller PE.

shiller pe ratio are stocks overvalued

But, the driver here is inflation. When inflation rates are really low, we can justify a higher price to earnings ratio for stocks, so they say.

A new VIX average level of 19 translates to the implied volatility of 19% on the S&P 500 instead of the former after of 20%. It isn’t a huge range difference.

Looking over the full 26 years of implied volaltity, the more elevated levels in the past included the late 90s into around 2003, which elevated the average. Since then, we’ve seen more spikes up but not as many volatility expansions that stay high for longer periods. ^VIX Chart

A behavior of implied volatility I’ve observed over time is it spikes up very fast when the stock market drops and then trends back down more gradually as stocks trend back up.  For this reason, derivatives of volatility provide us an opportunity for asymmetric hedging.

I doubt this is a new lower long term volatility regime. My guess is we’ll see a very significant volatility expansion again at some point during the next bear market and economic recession. Historically we’ve observed trends that stretch far and wide swing back the other way, far and wide.

At a minimum, it’s no time for complacency.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global TacticalMike Shell and Shell Capital Management, LLC is a registered investment advisor in Florida, Tennessee, and Texas focused on asymmetric risk-reward and absolute return strategies and provides investment advice and portfolio management only to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. Any opinions expressed may change as subsequent conditions change.  Do not make any investment decisions based on such information as it is subject to change. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. The views and opinions expressed in ASYMMETRY® Observations are those of the authors and do not necessarily reflect a position of  Shell Capital Management, LLC. The use of this website is subject to its terms and conditions.

 

 

Investor sentiment is dialed up with stock trends

I believe there are many factors that drive stock prices and one of them is investor sentiment. However, enthusiasm and panic can also reach extremes, which drives the opposite trend.

When investors are extremely bullish they help drives up as long as they keep buying stocks. But, at some point, their buying enthusiasm or capacity to buy gets exhausted and the buying pressure dries up. We saw this in rare form in 2017 as investor sentiment was excessively bullish as prices kept trending up. In the chart below I show the breakout after a very volatile period (yellow) and a smooth uptrend in 2017 (green line), but then it was interpreted sharply early 2018 and then corrected even more by the end of ’18.

trend following breaktout uptrend 2017 crash 2018 asymmetic returns risk reward

In fact, as an example of the challenge of this period, if we had applied a trend following system that entered the breakout above the 2015-16 trading range and but didn’t exit at some point in the uptrend, this stock index declined all the way back to the breakout entry point. SPX trading trend following breaktout uptrend 2017 crash 2018 asymmetic returns risk reward

We can say the same for buy and hold; if someone held stocks over this period the end of 2018 they were looking back three years without much capital gain. So, the point in time investors decide to do their lookback makes all the difference.

Back to investor sentiment…

Another observation about investor sentiment is after prices trend up, investors get more and more optimistic about prices trending up, so the trend and momentum itself attract stock buying enthusiasm. At major bull market peaks, like in 1999, it brings out the masses. I remember grandmothers cashing out bank CD’s wanting to buy stocks then.

The same applies on the downside. After prices fall, investors become more and more afraid of deeper losses in their portfolio, which results in more selling pressure.

Everyone has an uncle point, it can either be predefined like mine is, or you can find out the hard day after your losses get large enough you tap out at lower prices. 

Since I shared my observations of investor sentiment in You probably want to invest in stocks last week, the CNN Fear & Greed Index, made up of 7 investor sentiment indicators, remains dialed up to “Extreme Greed”, so investors and the market seem to be optimistic about up-trending stock prices.

Fear and Greed Index

In fact, based on the historical trend cycle of the CNN Fear & Greed Index the market seems to be as optimistic about up-trending stock prices as it’s been in years. Only late 2017 did we see as much enthusiasm.

Fear and Greed over time

Who remembers how that turned out?

2018 Drawdown in stocks loss

On sentiment indicator, I noted last week that wasn’t as bullish as others were the AAII Individual Investor Sentiment Survey. That changed this week.

US Investor Sentiment, % Bull-Bear Spread is at 14.33%, compared to 3.17% last week and 9.09% last year. This is higher than the long term average of 7.72%. investor sentiment chart bull bear spread

So, individual investors are bullish, according to AAII.

What’s driving all this enthusiasm for the stock market?

The trend is up, and here is a chart of the S&P 500 market capitalization showing the value of the stocks in the index based on the current price.

S&P 500 market capitalization cap history

Most investors follow trends whether they realize it or not. Trend following can be a good thing as long as the trend continues. It’s when the trends change we find out who’s who.

You can probably see why I believe it is essential to actively manage investment risk and apply robust drawdown controls to avoid the bad ending. For me, it’s a combination of predetermined exits to cut losses short and asymmetric hedging.

 



Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical. Mike Shell and Shell Capital Management, LLC is a registered investment advisor focused on asymmetric risk-reward and absolute return strategies and provides investment advice and portfolio management only to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. Any opinions expressed may change as subsequent conditions change.  Do not make any investment decisions based on such information as it is subject to change. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. The views and opinions expressed in ASYMMETRY® Observations are those of the authors and do not necessarily reflect a position of  Shell Capital Management, LLC. The use of this website is subject to its terms and conditions.

Volatility is expanding, a little

To no surprise, the CBOE S&P 500 Volatility Index that represents the market’s expectation of 30-day forward-looking volatility, is trending up. 

VIX VOLATILITY EXPANSION ASYMMETRIC RETURNS

So far, it isn’t much of a volatility expansion, but it’s elevated somewhat higher than it was. At around 15, the VIX is also well below its long term average of 18.23, although it hasn’t historically been drawn to the 18-20 level, anyway. The average is skewed by the spikes in volatility; volatility expansion. 

VIX is at a current level of 14.82, an increase of 0.80 or 5.71%% from the previous market day.

Here are the 50 and 200-day moving average values for VIX.

VIX MOVING AVERAGE

As I shared over the weekend, and it was quoted in today’s MarketWatch article “U.S.-Iran tensions will spark increased volatility — here’s how to play stocks, fund manager says“:

“So, on a short-term basis, the stock indexes have had a nice uptrend since October, with low volatility, so we shouldn’t be surprised to see it reverse to a short-term downtrend and a volatility expansion.

“For those who were looking for a ‘catalyst’ to drive a volatility expansion, now they have it.”

I was referring to the U.S. conflict with Iran, of course. 

The VIX index value is derived from the price inputs of the S&P 500 index options, it provides an indication of market risk and investors’ sentiments. VIX measures the implied ‘expected’ volatility of the US stock market. So, many market strategists use the VIX as a gauge for how fearful, uncertain, or how complacent the markets are. The VIX index tends to rise when the market drops and vice versa. During the 2008-2009 bear market, the VIX trended up as high as 80.86. Although the VIX cannot be invested in directly, securities like ETFs and derivatives based on it may provide the potential for an asymmetric hedge. For example, over the past year when the S&P 500 stock index was down -1% or more on the day, some of the ETFs based on long volatility spiked 10% or more. Volatility is difficult to time right, but when we do the payoff can be asymmetric. An asymmetric payoff is achieved when the risk-reward is asymmetric: maybe we risk 1% to achieve a payoff of 5%. Since long volatility has the potential for big spikes when volatility expands, it’s asymmetric payoff doesn’t require the tactical trader and risk manager to be as ‘right’ and accurate. So, the probability of winning can be lower, but the net pay off over time is an asymmetric risk-reward.

You can probably see why I pay attention to volatility and volatility expansions.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.Mike Shell and Shell Capital Management, LLC is a registered investment advisor focused on asymmetric risk-reward and absolute return strategies and provides investment advice and portfolio management only to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. Any opinions expressed may change as subsequent conditions change.  Do not make any investment decisions based on such information as it is subject to change. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. The views and opinions expressed in ASYMMETRY® Observations are those of the authors and do not necessarily reflect a position of  Shell Capital Management, LLC. The use of this website is subject to its terms and conditions.

 

 

Investor sentiment signals greed is driving stocks as the U.S. stock market reaches short term risk of a pullback

The Fear & Greed Index reaches the Extreme Greed level as I got a short term countertrend sell or hedge signal for U.S. stocks.

Investors are driven by two emotions: fear and greed.

Too much fear can drive stocks well below where they should be, an overreaction to the downside.

When investors get greedy, their enthusiasm to buy may drive stock prices up too far, an overreaction to the upside.

The Fear & Greed Index is a simple gauge that attempts to signal which emotion is driving the stock market. It’s made up of seven indicators, and though it doesn’t generate a perfect timing signal, it’s useful for investors to compare to their own sentiment.

fear greed index investor sentiment

As I pointed out last week, expected volatility has also declined to a low level. The VIX is now in the 12 range.

Here is a chart of the Fear & Greed index over time. As we highlighted, it’s at its historical peak.

fear greed index over time

Investors tend to want to do the wrong thing at the wrong time, so measuring extremes in overall investor sentiment is a useful way to modify investor behavior.

I operate with a massive intention of feeling the right feelings at the right time. Some claim to use systems to overcome their feelings or remove feelings altogether, but as a tactical decision-maker, I know it isn’t actually possible. I prefer to experence my emotions and let them be but have shifted my mindset to feel the right feeling at the right time.

Based on my systems and indicators, suggesting sentiment and price trends have reached a point of extreme, I feel more defense right now. My quantitative methods drive my feelings. I see the signal, get a good sense about it, then pull the trigger.

As sentiment is reaching the extreme greed level, as see the S&P 500 index below is at all-time new highs.

When I see such enthusiasm, it’s initially good for momentum, but it eventually fades and so does the price trend.

But, it doesn’t matter if we monitor quantitative measures without them driving our decisions. When I see points like this, it’s just a reminder to review my portfolio to see if I’m comfortable with the risk/reward exposures. If I see asymmetric risk/reward, I do nothing. If I have too much risk exposure, I reduce it or hedge it off.

We shouldn’t be surprised to see a decline of 2-5% from here or at least a pause, but anything is possible.

Being prepared in advance is a useful way to avoid bad investor behavior, which is why I predefined my exposure to the possibility of loss by knowing in advance when I’ll exit or reduce the exposure.

 

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

Mike Shell and Shell Capital Management, LLC is a registered investment advisor focused on asymmetric risk-reward and absolute return strategies and provides investment advice and portfolio management only to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. Any opinions expressed may change as subsequent conditions change.  Do not make any investment decisions based on such information as it is subject to change. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data are deemed reliable but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. The use of this website is subject to its terms and conditions.

I don’t always comment on economic indicators, but when I do, it’s a trend like ISM Manufacturing Index

The ISM Manufacturing Index monitors changes in production levels from month to month and is considered an important economic indicator by many global macro investment managers. Some of them consider a level above 50 as an indicator of a growing manufacturing sector.

However, the current level is now down to 47.30, down from 49.50 last month and down from 63.90 one year ago. This is a change of -4.44% from last month and -25.98% from one year ago.

Global Macro traders and investors who rely on economic indicators monitor the ISM Manufacturing Index to observe US economic trends and conditions. When the index is rising, they expect a bullish stock market in reaction to higher corporate earnings. Looking at the past year, the level is in a downtrend. As such, this downtrend may be bearish for the economy and stock market.

In fact, there seems to be a trend here as I broaded out the time horizon to see the bigger picture. ISM Manufacturing Index is also in a downtrend over the past three years.

We can say the same about the past five years. This economic indicator is trending down and in a downtrend.

Next is the 10-year trend. Over the past 10 years, the recent trend is notable.

Looking back over the full period I have data, which is before 1950, the historical trend suggests it could get worse, but it’s also at the lower range it has reached before it does.

So, this economic indicator suggests as investors, we had better be prepared and aware of the situation as tactical risk management is likely to be more obviously necessary for the near future. This is potentially negative for stocks from this point.

What about bonds?

The opposite is the case for bonds. Bonds may fall as the ISM Manufacturing Index rises and in an uptrend because of the sensitivity of bonds to inflation. However, when the ISM Manufacturing Index is declining like it is now and in a downtrend, it can be positive for bonds.

The funny thing is my directional price trend systems already have us meaningful exposure to long term U.S. Treasury bonds.

You see, I don’t have to know about economic indicators or follow them, my systems and methods identify when the trends are actually starting as well as when they reverse. When they do this well, we naturally get in sync with the price trends and what these economic indicators observe.

It looks like there are real signs of a slowing U.S. economy. As such, investors need to be prepared and not be complacent with non-risk managed holdings in their portfolio. I manage our risk at Shell Capital Management by predefining my exits on all of our holdings, hedging, and tactically investing in the direction of trends and sometimes likely countertrends. It’s what our clients pay us for. As this economic expansion is very aged as is the bull market in stocks, the only certainty is the change we’ll see in the future. What has been trending up so long will eventually trend down.

I’m as prepared as I’ve ever been and probably better now than I was in the past when I operated through such conditions.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

Mike Shell and Shell Capital Management, LLC is a registered investment advisor focused on asymmetric risk-reward and absolute return strategies and provides investment advice and portfolio management only to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. Any opinions expressed may change as subsequent conditions change.  Do not make any investment decisions based on such information as it is subject to change. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data is deemed reliable, but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. Use of this website is subject to its terms and conditions.

 

 

 

 

 

 

 

 

 

 

 

 

 

Implied volatility as measured by VIX indicates a volatility expansion in the near term

Implied volatility as measured by VIX indicates wider prices in the near term. The CBOE Volatility Index VIX has increased to 20, which is it’s long term average, suggesting prices will spread out to 20%.

Along with a volatility expansion, as typical, we are seeing stock prices trend down.

My leveraged exposure to the long term U.S. Treasuries has offered an asymmetric hedge in recently. The long term U.S. Treasuries don’t always play out this way, but this time we’ve benefited from their uptrend and some negative correlation with stocks.

Gold is another alternative used as a hedge exhibiting relative strength and time-series momentum.

 If this is just a short term correction, we should see some buying interest near this point or a little lower. If last month’s lows are taken out, this may be the early stage of a larger decline.

We were well-positioned in advance this time, so we’ll see how it all plays out.

 

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

Mike Shell and Shell Capital Management, LLC is a registered investment advisor focused on asymmetric risk-reward and absolute return strategies and provides investment advice and portfolio management only to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. Any opinions expressed may change as subsequent conditions change.  Do not make any investment decisions based on such information as it is subject to change. Investing involves risk, including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data is deemed reliable, but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. Use of this website is subject to its terms and conditions.

 

 

 

 

 

 

 

 

 

 

 

Charting and technical analysis of the stock market trend

I usually share more of my observations of the stock market trend when the shit hits the fan. The truth is, I enjoy volatility expansions more than the quiet, calm trends. There isn’t as much for me to talk about when the trends are calm and quiet.

I also try to point out, in advance, when I believe we may see a volaltity expansion like we are now. You shouldn’t expect it from me as I’m ultimately an investment manager, not a Mark Twain, so my own tactical trading decisions are my priority. Also, what I share here doesn’t necessarily represent what I am trading in our managed portfolios. In fact, I usually try to avoid mentioning any symbol, stock, ETF, etc. that I may be trading or invested in. As such, use my observations at your own risk as it is not investment advice. With that said…

Here is the one year chart of the S&P 500 with some basic technical analysis applied. The blue trend line I drew overhead is where we would have expected to see “resistance become support,” but it hasn’t. So, there wasn’t enough buying demand to overcome selling pressure today. Based purely on quantitative measures as I’ve shared over the past week, it isn’t a surprise to see a volatility expansion and price trends widen out.

stock market momentum and support resistence

I marked how the current decline relates to the past two. This one has turned down rather sharply and quickly as of today. The SPX stock index is down about -6% from it’s high of which nearly half of the loss is today.

I now expect we’ll see some buying interest step in… at least temporarily. Only time will tell if this becomes a waterfall decline like we saw October to December, or worse.

I haven’t mentioned any news items that could be used as catalysts. Last week it was the Fed and employment, today it’s China, Hong Kong, and Trump tweets. Contrary to what most people probably believe, the range of prices broadening out and price trends falling is something I thought we may see as a normal quantitative reaction. Whatever may get the blame, it’s just the market, doing what it does. I can assure you of only one thing: I’ve heard a wide variation of reasons today from different levels of people. On the financial news, it’s one thing, from global macro hedge fund managers, it’s another. For example, one mentioned the Chinese PLA army is building on the Hong Kong border…

“May you live in interesting times” 

Ironically, it is an English expression purported to be a translation of a traditional Chinese curse.

In the meantime, my short term momentum systems are showing the broad stock index reaching its lower range of probabilities, so we “should” see it retrace up at some point, at least temporarily. Of course, there is always a chance of a waterfall decline the moves much deeper than a normal range of probabilities. In fact, we have already seen that now if you look at the chart. The price trend has moved below the “normal range of the market” as measured by the lower band.

We’ll see how it all unfolds.

If you want to follow along, sign up on the right to get automatic emails immediately when I share a new observation. 


Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

Mike Shell and Shell Capital Management, LLC is a registered investment advisor and provides investment advice and portfolio management exclusively to clients with a signed and executed investment management agreement. The observations shared on this website are for general information only and should not be construed as advice to buy or sell any security. Securities reflected are not intended to represent any client holdings or any recommendations made by the firm. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. All information and data is deemed reliable, but is not guaranteed and should be independently verified. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. Use of this website is subject to its terms and conditions.

Asymmetry in the CBOE Index Put/Call Ratio suggests hedging

I pointed out yesterday the Stock market internals are signaling an inflection point. On a short term basis, some internal indicators are suggesting the stock market is at a point I expect to see a more significant breakout in one direction or another. That may sound like a symmetrical statement, but it’s the result of a symmetrical point that I consider midfield. From here, I look for signals of which direction the momentum shifts.

The asymmetry in the CBOE Index Put/Call Ratio suggests an increase in hedging yesterday. In the chart below, we see the Put/Call Ratio on Index options is at the high end of its range. I believe index options are used more for hedging by large institutions like hedge funds and pensions than for speculation by smaller individuals. I must not be the only one who recently hedged market risk. 

cboe index put:call ratio asymmetric hedging

Looking back over the full history, we see the current asymmetry of 1.55 puts to calls is a level that shows the asymmetry is on the upper range. When it gets too extreme, it can signal an overly pessimistic position.

cboe index put call long term history asymmetric hedge

The CBOE Equity Put/Call Ratio which I believe is more of a measure of individual investor speculation remains at a normal level at this point. That is, we normally see the Equity Put/Call Ratio below 1 as it indicators more (speculative) call volume than put volume.

equity put call ratio asymmetric risk reward hedging

However, when the Equity Put/Call Ratio spiked up to an extreme in late December I thought it was a good indicator of panic. That turned out to be the case as it marked the low so far.

From here, I’m looking for signs of which direction the momentum is shifting. The CBOE Index Put/Call Ratio seems to suggest professional investors like me are more concerned about hedging against downside loss. They may be like me, setting on capital gains I prefer to hold (let the winners run!) so adding a hedge can help offset a loss of value. Yet, if we see a continuation up in the recent uptrend we simply take a smaller loss on the hedges that we can tax deduct.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

The observations shared on this website are for general information only and are not specific advice, research, or buy or sell recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. Use of this website is subject to its terms and conditions.

Observations of the stock market decline and volatility expansion

Observations of the stock market decline and volatility expansion

On September 25th I shared in VIX level shows market’s expectation of future volatility when I pointed out a low level of expected volatility as implied by the VIX index.

I said:

The current level of the VIX index has settled down to a lower historical level suggesting the market expects the future range of the price of the S&P 500 to be lower. Below is the current level relative to the past year.

I went on to explain my historical observations of volatility cycles driven by investor behavior:

The VIX Index is intended to provide a real-time measure of how much the market expects the S&P 500 Index to fluctuate over the next 30 days. The VIX Index reflects the actual order flow of traders

Since investors tend to extrapolate the recent past into the future, they usually expect recent calm markets to continue and violent swings to persist.

After the stock market declines and volatility expands, investors extrapolate that recent experience into the future and expect volatility to continue. Sometimes it does continue, but this time it gradually declined as the price trend became calmer.

When markets have been calm, traders and investors expect volatility to remain low. Before February, the VIX implied volatility had correctly predicted low realized volatility for months. But, both realized and expected volatility was so low that many investors were shocked when stock prices fell sharply, and volatility expanded.

When the market expects volatility to be low in the next 30 days, I know it could be right for some time. But, when it gets to its historically lowest levels, it raises situational awareness that a countertrend could be near. It’s just a warning shot across the bow suggesting we hedge what we want to hedge and be sure our risk levels are appropriate.

I shared the chart below, showing implied volatility at the low end of the cycle over the past year:

Since that date, we’ve indeed witnessed a volatility expansion of more than 90% in the VIX index and a decline in the S&P 500 stock index over -6%.  Implied volatility has expanded and stocks declined. As implied volatility is now starting to contract, below we can see the recent expansion as it trended from 12 to 24. Today its back to its long-term average of 20.

Stock market indexes, both U. S. and international, have declined 6 – 7% from their highs.

At this point, this has been a normal short-term cycle swing in an ongoing uptrend that is frequently referred to as a “correction.”

To be sure, we can see by looking at the % drawdowns in the primary uptrend that started in March 2009.

Markets cycle up and down, even within overall primary uptrends. As we see over a nine-year period, the current decline is about average and half as deep as the largest declines since 2009.

You can probably see what I meant by situational awareness of the markets cycles, trends, and volatility levels.

It isn’t enough to just say it or write about it. My being aware of the situation helps me to do what I said, which is worth repeating:

But, when it gets to its historically lowest levels, it raises situational awareness that a countertrend could be near. It’s just a warning shot across the bow suggesting we hedge what we want to hedge and be sure our risk levels are appropriate.

As far as the stock market condition, I like to see what is going on inside. Just as volatility swings up and down in cycles, so do price trends. As I’ve pointed out before, I observe prices swinging up and down often driven by investor behavior. For example, many investors seem to oscillate between the fear of missing out and the fear of losing money.

“The less the prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own.” – Warren Buffett

One visual way to observe the current stage is the breadth of the stock market as I shared last week in The Stock Market Trend. Below is the percent of stocks in the S&P 500 index trending above their 50 day moving averages often used as a short-term trend indicator. This is a monthly chart since 2009 so we can see how it oscillates up and down since the bull market started. At this point, the number of stocks falling into short-term downtrends is about what we’ve seen before.

stock market breadth asymmetric risk

The risk is: this continues to be an aged old bull market, so anything is possible. That is why my focus every day is situational awareness. But, there is always a risk of a -10% or more decline in the stock market, regardless of its age or stage.

The good news is, we’ve now experienced some volatility expansion, stocks have now pivoted down to the lower end of their cycles, so maybe volatility will contract and stock prices resume their uptrend.

We’ll see.

All that is left to do is observe, be prepared, and respond tactically as it all unfolds.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

The observations shared on this website are for general information only and are not specific advice, research, or buy or sell recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. Use of this website is subject to its terms and conditions.

The Stock Market Trend

The stock market declined with heavy selling pressure on a major stock market anniversary that I haven’t heard anyone mention.

October 10, 2018, is the 10-year anniversary of the waterfall decline of 2008.

Below is the S&P 500 stock index from October 9, 2007 to October 10, 2008. I remember it very well. It was the first part of the waterfall decline up to this day 10 years ago.

stock market decline 2008

But, as a reminder, while this bear market is often called the “2008 Financial Crisis” and misquoted as being only about the year 2008, it actually continued through March 9, 2009.

average length of bear market crash 2008.jpg

With stock indexes only about -5% or so off their all-time highs, we are far from that today.  But, the stock market decline today was impressive in magnitude and broad across all sectors.

stock market sector ETF October 10 2018

The breadth of the decline was unmistakable by the 50% decline in the % of stocks in the S&P 500 trading above their 50 day moving average. The percentage of stocks trading above the moving average is a breadth indicator that measures internal strength or weakness in the stocks in the index and the index itself. We say that breadth is strong when the majority of stocks in an index are trading above their moving average. Since the 50-day moving average is used to measure the short-medium term trend, it reveals that only 24% of the 500 stocks in the S&P 500 index are above their short-term trend.

percent of stocks above 50 day moving average SPX SPY.jpg

I colored the top red and the bottom green because the extreme highs and extreme lows can signal overbought and oversold levels.

The indicator is an oscillator that cycles between 0% and 100%.

After most stocks have trended up, we say an uptrend has broad participation, which is positive. However, markets cycle and oscillate up and down, so once most stocks have already been in uptrends at some point they reverse back down.

After most stocks have trended down, we say a downtrend becomes washed out. As selling eventually gets exhausted because those who want to sell have already sold.

Next, we observe the % of stocks in the S&P 500 index that are trending above their 200 day, which a longer term trend signal. 19% of the stocks declined below their 200 day moving average today leaving about half of the stocks still in a longer-term uptrend.

SPX BREADTH PERCENT OF STOCKS ABOVE 200 DAY MOVING AVERAGE

Since we are talking about moving averages and the S&P 500, below is the index itself with the 50 and 200 day moving average. Notice the 50 day moving average has been too tight to contain the uptrend. In other words, entering and exiting it would lead to many buys and sells and whipsaws like in June. The 200 day has better contained the trend since April, but notice if it were used as an exit it would have resulted in selling at the low. This observation is just using these moving averages as a very simple way to define uptrend vs. downtrend, it is not a complete trading system. Such measures are never perfect, and they don’t have to be.

stock market SPX 200 day moving average trend following

Today’s decline was impressive because the stock indexes declined over -3% in a single day. One day doesn’t make a trend, but it was enough to erase most of the year to date gains for the stock index.

stock market year to date 2018 trend following momentum

 

The Dow Jones Industrial Average of 30 of America’s largest companies declined even more than the S&P 500. There was even more weakness in small companies, momentum stocks, and an ETF tracking the top-ranked growth and momentum stocks by Investor’s Business Daily declined nearly -6%. As a proxy for leading growth and momentum stocks, this is an indication the leaders declined the most today.

stock market momentum ETF trend following asymmetric

You can probably see why I believe it’s essential to actively manage risk by knowing in advance when to exit a loser to cut losses short as well as understanding the market risk level. For those of us who weren’t fully exposed to the decline who have the capital to eventually buy at lower prices, we get to take advantage of a falling trend.

Over the past week, I shared observations of volatility expansion as the implied volatility index has been trending up. Below is its year to date trend.

VIX VOLATILITY EXPANSION

Here it is over the past week since I mentioned it. I included the S&P 500 stock index to illustrate as the stock market declined about -5% the past week, implied volatility expanded 98%.

SPY SPX VIX ASYMMETRIC RISK REWARD

We’ll see in the days and weeks ahead if this is the beginning of a more significant downtrend that becomes a waterfall decline or if it was enough to exhaust the selling pressure of those who wanted to sell.

 

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

The observations shared on this website are for general information only and are not specific advice, research, or buy or sell recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. Use of this website is subject to its terms and conditions.

 

The volatility expansion continues like tropical storm Michael that could become a hurricane

The volatility expansion observation I shared last week has continued.

If you haven’t followed along, I suggest reading VIX level shows the market’s expectation of future volatility and Here comes the volatility expansion to see where I am coming from.

Implied volatility as measured by the CBOE Volatility Index $VIX has gained about 45% in the past three trading sessions, so volatility is expanding.

VIX $VIX VOLATILITY EXPANSION VOL TRADING ASYMMETRIC.jpg

I discussed what a rising VIX and volatility expansion means in the prior observations.

Rising implied volatility means rising expectations for future volatility as implied by options prices. Ultimately, Implied volatility is determined by the price of options contracts.

In other words, implied volatility is driven by supply and demand and order flow.

An increase in options buying increases the price of options which results in higher implied volatility.

The net selling of options decreases the price of options which results in lower implied volatility.

Volatility isn’t directional.

Volatility is a measure of movement and how wide prices spread out, which says nothing about the direction of the price trend. Prices can be trending up sharply and volatility measures could expand.

Here are some examples:

Trending up with volatility expansion: a price trend that gains 10% a day for several days is a directional uptrend, but it’s also volatile. We would say the trend is up, but it’s also a volatility expansion as the price range is expanding.

Non-trending with volatility expansion: a price trend that cycles up and down around 5% a day for a long time with no clear direction up or down is a non-trending condition, but it’s also volatile. We would say it is non-trending, but it’s also a volatility expansion.

Trending down with volatility expansion: a price trend that declines 10% a day for several days is clearly a downtrend, with volatility. We could say the trend is down with expanding volatility.

Most of the time, the risk is asymmetric since we tend to see increased volatility when we see falling prices. As prices fall, more investors and traders respond to the simple fact the prices are falling and they are losing money. This serial correlation with falling prices can lead more prices falling even more as investors sell because prices are falling.

However, occasionally we may observe prices trending down with volatility contraction. A falling price trend with contracting volatility is necessarily going to be a slower downtrend with less directional movement. Instead of 5% or 10% declines, it may be 1 or 2% declines. A downtrend without volatility expansion would be observed as a slower decline that would necessarily take longer for a large loss to develop. For example, a -30% loss would happen much faster with -10% down periods than it would at a rate of -1%. You can probably see how volatility expansions in downtrends get the attention of someone who wants to manage their drawdown.

I’ll share some more detailed ways to observe volatility to decide if volatility is expanding or contracting.

At the top of the chart is the S&P 500 stock index. The bands around the stock index are 2 times the stock index average true range over the past 20 days. The dotted line in the center of the bands is the 10-day moving average. Price trends move in cycles, so they oscillate up and down over time. When we apply bands around the price trend is gives us a visual representation of a “normal” range of prices around the trend. We observe the price trend tends to oscillate or cycle up and down within certain parameters – the range. When this range spreads out, I call it volatility expansion. When the range contracts, it’s volatility contraction. Volatility itself also tends to cycle between expansion and contraction. We can see that here.

volatility expansion stock market VIX ATR

Below the price trend chart with bands of the average true range (ATR) I included a chart of ATR, standard deviation, and the VIX. Both standard deviation and average true range are actual, historical, and realized volatility. These indicators are measuring how the price of the index has actually expanded or contracted. As I pointed out before, the VIX is a measure of options prices on the stocks in this index, so it’s driven by expectations of future volatility over the next 30 days determined by the price of options. ATR and standard deviation are the actual range of movement of the index.

I started with the year-to-date time frame to show how the price trend spread out as it started swinging up and down at the beginning of the year and has since trended up with lower volatility; smaller cycles, smaller swings.

Just as we observe market price trends tend to cycle and swing up and down over time, so does volatility. p

  • Price trends may reach an extremely high or low point, then reverse in the other direction.
  • Volatility may reach an extremely high or low point, then reverse in the other direction.

When we see volatility reach an extreme low/high point, we can expect to see it drift the other way eventually. Investors and traders who only believe trends in price and volatility only go one way are those who get surprised and caught in a loss trap.

Now, let’s zoom in for a closer look with just a three-month time frame to observe what has been going on more recently.

I highlighted in green the recent volatility expansion I pointed out last week. Notice the forward-looking VIX index at the bottom turned up sharper and has trended up higher than its last cycle high last month. However, realized historical volatility as measured by standard deviation and the average true range of index prices has also trended up, but on a lag relative to the forward-looking VIX.

Volatility expansion stock market risk management vix asymmetric risk reward

So, you can probably see why I’m calling it a volatility expansion. It is drifting up, though it could certainly trend up a lot more, or it could reverse back down. For now, the rising prices in options suggest there is demand for protection and it is probably in response to something the market believes may lead to increase risk or volatility. It could be something seasonal like earnings season or it could be as simple as the month of October is historically one of the most volatile months.

Speaking of October…

October is a typical month to see hurricanes in the Gulf and Atlantic, too. Right now, we have Michael (no relation) coming up through the Gulf of Mexico. As of this morning, Michael was just a named storm, but its expected to expand into a Category 2 or 3 hurricane by the time it reaches the Florida panhandle to our favorite places like Sandestin, Miramar Beach, Destin, and the 30A area like Rosemary Beach and Alys Beach. The intensity, speed, and how wide the storm spreads out to reach higher categories is a lot like volatility expansion in market price trends. Most people prefer to experience calm and quiet. We would prefer to see the storm contract and slow down its speed.

Although the tropical storm monitors have ways of measuring the probability of speed, expansion, etc. we are always dealing with the certainty of uncertainty. Hurricanes can shift and drift in different directions, speed up or slow down, and expand or contract. How we respond is a matter of situational awareness of measuring the cone of uncertainty as best we can. Some of us do it better than others. Some of us prepare more timely and respond better than others.

Right now we have some volatility expansion and we are positioned as such. The implied volatility index suggests the market believes we’ll see some price swings (up and down) this month.

We’ll see how it all plays out.

Semper Gumby (Always Flexible).

Let’s hope Michael doesn’t give me a bad name.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

The observations shared in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results.

 

 

 

 

 

 

Here comes the volatility expansion

Nine days ago in VIX level shows market’s expectation of future volatility I shared an observation that the implied volatility VIX, a measure of expected future volatility that is implied by option prices, had reached an extremely low point. I explained what that means and how I use it:

When the market expects volatility to be low in the next 30 days, I know it could be right for some time.

But, when it gets to its historically lowest levels, it raises situational awareness that a countertrend could be near.

Today we have some volatility expansion.

The VIX Volatility Index has gained 35%. It implies the market now expects higher volatility. Specifically, the market expects the range of prices to spread out over 15% instead of 12%.

VIX $VIX Volatility Expansion asymmetry asymmetric convexity divergence

The popular stock indexes are down over -1% for the first time in a while.

stock market asymmetry asymmetric risk

As I said nine days ago, it should be no surprise to see some volatility expansion. Volatility is mean reverting, which means it tends to oscillate in a high and low range and reverse back to an average after its reaches those cycle highs and lows.

Implied volatility had reached its historical low end, so it’s expanding back out. Stock prices are also spreading out and declining so we shouldn’t be surprised to see more movement in prices in the coming weeks.

At around the same time volatility was contracting and calm, my momentum indicators were signaling stock indexes and many individual stocks were reaching short-term extreme levels that often preceded a short-term decline. These systems prompt me tactically reduce exposure to stocks to dynamically manage our risk.

Only time will tell how it all plays out. We’ll see how it unfolds from here.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

The observations shared in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results. The presence of this website on the Internet shall in no direct or indirect way raise an implication that Shell Capital Management, LLC is offering to sell or soliciting to sell advisory services to residents of any state in which the firm is not registered as an investment advisor. 

Asymmetry of Loss: Why Manage Risk?

“The essence of portfolio management is the management of risks, not the management of returns.” —Benjamin Graham

Why actively manage investment risk?

Why not just buy and hold markets and ride through their large drawdowns?

Losses are asymmetric and loss compounds exponentially.

The larger the loss, the more gain is required to recover the loss to get back to breakeven.

The negative asymmetry of loss starts quickly, losses more than -20% decline start to compound against you exponentially and with a greater magnitude the larger the loss is allowed to grow.

If your investment portfolio experiences a -20% loss, it needs a 25% gain to get back the breakeven value it was before the loss.

asymmetry of loss losses asymmetric exponential

At the -30% loss level, you need a 43% gain to get it back.

Diversification is often used as an attempt to manage risk by allocating capital across different markets and assets.

Diversification and asset allocation alone doesn’t achieve the kind of risk management needed to avoid these large declines in value. Global markets can fall together, providing no protection from loss.

For example, global markets all fell during the last two bear markets 2000-2003 and 2007-2009.

global asset allocation diversification failed 2008

It didn’t matter if you had a global allocation portfolio diversified between U.S. stocks, international stocks, commodities, and real estate REITs.

Diversification can fail when you need it most, so there is a regulatory disclosure required: Diversification does not assure a profit or protect against loss.

This is why active risk management to limit downside loss is essential for investment management.

I actively manage loss by knowing the absolute point I’ll exit each individual position and managing my risk level at the portfolio level.

Active risk management, as I use it, applies tactics and systems to actively and dynamically decrease or increase exposure to the potential for loss.

My risk management systems are asymmetric risk management systems. Asymmetric risk management intends to manage risk with the objective of a positive asymmetric risk/reward.

My asymmetric risk management systems are designed to cut losses short, but also protects and manages positions with a profit.

After markets trend up for a while without any significant interruption, investors may become complacent and forget the large damage losses can cause to their capital and their confidence. When investors lose confidence in the markets, they tap-out when their losses are allowed to grow to large.

I prefer to stop the loss before it gets too large. How much is too large depends on the client, but also the math. As seen here, I have a mathematical basis for believing I should actively manage investment risk.

It’s why I’ve been doing it for two decades. Because I understood the math, I knew I had to do it over twenty years ago and developed the systems and tactics that proved to be robust in the devastating bear markets I’ve executed through since then.

 

Mike Shell is the Founder, and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Managed Portfolios and ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

The observations shared in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results.

Is it a stock pickers market?

Is it a stock pickers market?

Sometimes the stock market is trending so strongly that the rising tide lifts all boats. No matter what stocks or stock fund you invest in, it goes up. That was the case much of 2017.

Then, there are periods when we see more divergence.

When we observe more divergence, it means stocks, sectors, size, or style has become uncorrelated and are trending apart from each other.

I pointed out in Sector Trends are Driving Equity Returns; there is a notable divergence in sector performance, and that is driving divergence in size and style. Growth stocks have been outperformance value, and it’s driven by strong momentum in Technology and Consumer Discretionary sectors.

When specific sectors are showing stronger relative momentum, we can either focus more on those sectors rather than broad stock index exposure. Or, we can look inside the industry to find the leading individual stocks.

For example, Consumer Discretionary includes industries like automobiles and components, consumer durables, apparel, hotels, restaurants, leisure, media, and retailing are primarily represented in this group. The Index includes Amazon, Home Depot, Walt Disney, and Comcast. Consumer Discretionary is the momentum leader having trended up 9.7% so far this year as the S&P 500 has only gained just under 1%.

momentum sectors

If we take a look inside the sector, we see the leaders are diverging farther away from the sector ETF and far beyond the stock market index.

momentum stocks consumer discretionary sector NFLX AMZN AAPL

In fact, all the sectors 80 stock holdings are positive in 2018.

The Consumer Discretionary sector is about 13% of the S&P 500. As you can see, if these top four or five sectors in the S&P 500 aren’t trending up it is a drag on the broad stock index.

ETF Sector Allocation exposure S&P 500

So, Is it a stock pickers market? 

When we see more divergence, it seems to be a better market for “stock pickers” to separate the winners from the losers.

Another way to measure participation in the market is through quantitative breadth indicators. Breadth indicators are a measure of trend direction “participation” of the stocks. For example, the percent of the S&P 500 stocks above or below a moving average is an indication of the momentum of participation.

Below is the percent of stocks above their 50 day moving average tells us how many stocks are trending above their moving average (an uptrend). Right now, the participation is symmetrical; 52% of the stocks in the S&P 500 are in a positive trend as defined by the 50 day moving average. We can also see where that level stands relative to the stock market lows in February and April and the all-time high in January when over 85% of stocks were in an uptrend. By this measure, only half are trending up on a shorter term basis.

SPX SPY PERCENT OF STOCKS ABOVE 50 DAY MOVING AVERAGE 1 YEAR

The 200-day moving average looks back nearly a year to define the direction of a trend, so it takes a greater move in momentum to get the price above or below it. At this point, the participation is symmetrical; 55% of stocks are above their 200-day moving average and by this time frame, it hasn’t recovered as well from the lows. The percent of stocks above their 200-day moving average is materially below the 85% of stocks that were participating in the uptrend last year. That is, 30% fewer stocks are in longer trend uptrends.

SPY SPX PERCENT OF STOCKS ABOVE 200 DAY MOVING AVERGAGE 1 YEAR

In the above charts, I only showed a one-year look back of the trend. Next, we’ll take a step back to view the current level relative to the past three years.

The percent of stocks above their 50 day moving average is still at the upper range of the past three years. The significant stock market declines in August-September 2015 and December-January hammered the stocks down to a very washed out point. During those market declines, the participation was very asymmetric: 90% of the stocks were in downtrends and only about 10% remained in shorter-term uptrends.

SPX SPY PERCENT OF STOCKS ABOVE 50 DAY MOVING AVERAGE 3 YEARS

The percent of stocks above their 200 day moving average also shows a much more asymmetrical situation during the declines in 2015 and 2016 when the stock index dropped around -15% or more. Only 20% of stocks remained in a positive trend.

SPX PERCENT OF STOCKS ABOVE 200 DAY MOVING AVERAGE 3 YEARS

Is it a stock pickers market?

Only about half of the stocks in the index are in uptrends, so the other half isn’t. So, if we avoid the half that are in downtrends and only maintains exposure to stocks in uptrends and the trends continue, we can create alpha.

But, keep in mind, that doesn’t necessarily mean we should have any exposure at all in the S&P 500 stock index because happens to have the highest sector exposure in the leading sectors.

But, for those who want to engage in “stock picking”, the timing has a higher probability now to diverge from the stock index than last year because so fewer stocks are in uptrends and more are in downtrends.

For individual stocks traders willing to look inside the box, this is a good thing.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

The observations shared in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results.

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 economists 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 backward than we feel good about getting better off. I don’t like to go backward, 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: Shell Capital Management, LLC.

 

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

“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 correlate 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 it’s 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 is 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

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, options, or ETNs that invest in VIX 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

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