Stock Market Decline is Broad

We typically expect to see small company stocks decline first and decline the most. The theory is that smaller companies, especially micro companies, are more risky so their value may disappear faster.  Below, we view the recent price trends of four market capitalization indexes: micro, small, mid, and mega. We’ll use the following index ETFs.

Vanguard ETFs small mid large micro cap

Since we are focused on the downside move, we’ll only observe the % off high chart. This shows what percentage the index ETF had declined off its recent highest price (the drawdown). We’ll also observe different look-back periods.

We first look back 3 months, which captures the full extent of the biggest loser: as expected, the micro cap index. The iShares Micro-Cap ETF (IWC: Green Line) seeks to track the investment results of an index composed of micro-capitalization U.S. equities. Over the past 3 months (or anytime frame we look) it is -13% below its prior high. The second largest decline is indeed the small cap index. The Vanguard Small-Cap ETF (VB: Orange Line) seeks to track the performance of the CRSP US Small Cap Index, which measures the investment return of small-capitalization stocks. The small cap index has declined -11.5%. The Vanguard Mega Cap ETF (MGC) seeks to track the performance of a benchmark index that measures the investment return of the largest-capitalization stocks in the United States and has declined -9.65%. The Vanguard Mid-Cap ETF (VO) seeks to track the performance of a benchmark index that measures the investment return of mid-capitalization stocks and has declined -9.41%. So, the smaller stocks have declined a little more than larger stocks.

Small and Micro caps lead down

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

Many active or tactical strategies may shift from smaller to large company stocks, hoping they don’t fall as much. For example, in a declining market relative strength strategies would rotate from those that declined the most to those that didn’t. The trouble with that is they may still end up losing capital and may end up positioned in the laggards long after a low is reached. They do that even though we may often observe the smallest company stocks rebound the most off a low. Such a strategy is focused on “relative returns” rather than “absolute returns“. An absolute return strategy will instead exit falling trends early in the decline with the intention of avoiding more loss. We call that “trend following” which has the objective of “cutting your losses short”. Some trend followers may allow more losses than others. You can probably see how there is a big difference between relative strength (focusing on relative trends and relative returns)  and trend following (focusing on actual price trends and absolute returns).

So, what if we look at the these stock market indexes over just the past month instead of the three months above? The losses are the same and they are very correlated. So much for diversification. Diversification across many different stocks, even difference sizes, doesn’t seem to help in declining markets on a short-term basis. These indexes combined represent thousands of stocks; micro, small, medium, and large. All of them declined over -11%, rebounded together, and are trending down together again.

stock market returns august 2015

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

If a portfolio manager is trying to “beat the market” index, he or she may focus on relative strength or even relative value (buy the largest loser) as they are hoping for relative returns compared to an index. But a portfolio manager who is focused on absolute returns may pay more attention to the actual downside loss and therefore focuses on the actual direction of the price trend itself. And, a key part is predefining risk with exits.

You can probably see how different investment managers do different things based on our objectives. We have to decide what we want, and focus on tactics for getting that.

Low Volatility Downside was the Same

In Low Volatility and Managed Volatility Smart Beta is Really Just a Shift in Sector Allocation I ended with:

“Though the widening range of prices up and down gets our attention, it isn’t really volatility that investors want to manage so much as it is the downside loss of capital.

As a follow-up, below we observe the  PowerShares S&P 500® Low Volatility Portfolio declined in value about -12% from its high just as the SPDRs S&P 500® did. So, the lower volatility weighting didn’t help this time as the “downside loss of capital ” was the same.

SPLV PowerShares S&P 500® Low Volatility Portfolio

Source: http://www.ycharts.com

Why Index ETFs Over Individual Stocks?

A fellow portfolio manager I know was telling me about a sharp price drop in one of his positions that was enough to wipe out the 40% gain he had in the stock. Of course, he had previously told me he had a quick 40% gain in the stock, too. That may have been his signal to sell.  Biogen, Inc (BIIB) recently declined about -30% in about three days. Easy come, easy go. Below is a price chart over the past year.

Biogen BIIB

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

Occasionally investors or advisors will ask: “Why trade index ETFs instead of individual stocks?“. An exchange-traded fund (ETF) is an investment fund traded on stock exchanges, much like stocks. Until ETFs came along the past decade or so, gaining exposure to sectors, countries, bond markets, commodities, and currencies wasn’t so easy. It has taken some time for portfolio managers to adapt to using them, but ETFs are easily tradable on an exchange like stocks. Prior to ETFs, those few of us who applied “Sector Rotation” or “Asset Class Rotation” or any kind of tactical shifts between markets did so with much more expensive mutual funds. ETFs have provided us with low cost, transparent, and tax efficient exposure to a very global universe of stocks, bonds, commodities, currencies, and even alternatives like REITs, private equity, MLP’s, volatility, or inverse (short). Prior to ETFs we would have had to get these exposures with futures or options. I saw the potential of ETFs early, so I developed risk management and trend systems that I’ve applied to ETFs that I would have previously applied to futures.

On the one hand, someone who thinks they are a good stock picker are enticed to want to get more granular into a sector and find what they believe is the “best” stock. In some ways, that seems to make sense if we can weed out the bad ones and only hold the good ones. It really isn’t so simple. I view everything a reward/risk ratio, which I call asymmetric payoffs. There is a tradeoff between the reward/risk of getting more detailed and focused in the exposure vs. having at least some diversification, such as exposure to the whole sector instead of just the stock.

Market Risk, Sector Risk, and Stock Risk

In the big picture, we can break exposures into three simple risks (and those risks can be explored with even more detail). We’ll start with the broad risk and get more detailed. Academic theories break down the risk between “market risk” that can’t be diversified away and “single stock” and sector risk that may be diversified away.

Market Risk: In finance and economics, systematic risk (in economics often called aggregate risk or undiversifiable risk) is vulnerable to events which affect aggregate outcomes such as broad market declines, total economy-wide resource holdings, or aggregate income. Market risk is the risk that comes from the whole market itself. For example, when the stock market index falls -10% most stocks have declined more or less.

Stock and Sector Risk: Unsystematic risk, also known as “specific risk,” “diversifiable risk“, is the type of uncertainty that comes with the company or industry itself. Unsystematic risk can be reduced through diversification. If we hold an index of 50 Biotech stocks in an index ETF its potential and magnitude of a  large gap down in price is less than an individual stock.

You can probably see how holding a single stock like Biogen  has its own individual risks as a single company such as its own earnings reports, results of its drug trials, etc. A biotech stock is especially interesting to use as an example because investing in biotechnology comes with a unique host of risks. In most cases, these companies can live or die based on results of drug trials and the demand for their existing drugs. In fact, the reason Biogen declined so much is they reported disappointing second-quarter results and lowered its guidance for the full year, largely because of lower demand for one of their drugs in the United States and a weaker pricing environment in Europe. That is a risk that is specific to the uncertainty of the company itself. It’s an unsystematic risk and a selection risk that can be reduced through diversification. We don’t have to hold exposure to just one stock.

With index ETFs, we can gain systematic exposure to an industry like biotech or a sector like healthcare or a broader stock market exposure like the S&P 500. The nice thing about an index ETF is we get exposure to a basket of stocks, bond, commodities, or currencies and we know what we’re getting since they disclose their holdings on a daily basis.

ETFs are flexible and easy to trade. We can buy and sell them like stocks, typically through a brokerage account. We can also employ traditional stock trading techniques; including stop orders, limit orders, margin purchases, and short sales using ETFs. They are listed on major US Stock Exchanges.

The iShares Nasdaq Biotechnology ETF objective seeks to track the investment results of an index composed of biotechnology and pharmaceutical equities listed on the NASDAQ. It holds 145 different biotech stocks and is market-cap-weighted, so its exposure is more focused on the larger companies. It therefore has two potential disadvantages: it has less exposure to smaller and possibly faster growing biotech stocks and it only holds those stocks listed on the NASDAQ, so it misses some of the companies that may have moved to the NYSE. According to iShares we can see that Biogen (BIIB) is one of the top 5 holdings in the index ETF.

iShares Biotech ETF HoldingsSource: http://www.ishares.com/us/products/239699/ishares-nasdaq-biotechnology-etf

Below is a price chart of the popular iShares Nasdaq Biotech ETF (IBB: the black line) compared to the individual stock Biogen (BIIB: the blue line). Clearly, the more diversified biotech index has demonstrated a more profitable and smoother trend over the past year. And, notice it didn’t experience the recent -30% drop that wiped out Biogen’s price gain. Though some portfolio managers may perceive we can earn more return with individual stocks, clearly that isn’t always the case. Sometimes getting more granular in exposures can instead lead to worse and more volatile outcomes.

IBB Biotech ETF vs Biogen Stock 2015-07-29_10-34-29

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

The nice thing about index ETFs is we have a wide range of them from which to research and choose to add to our investable universe. For example, when I observe the directional price trend in biotech is strong, I can then look at all of the other biotech index ETFs to determine which would give me the exposure I want to participate in the trend.

Since we’ve observed with Biogen the magnitude of the potential individual risk of a single biotech stock, that also suggests we may not even prefer to have too much overweight in any one stock within an index. Below I have added to the previous chart the SPDR® S&P® Biotech ETF (XBI: the black line) which has about 105 holdings, but the positions are equally-weighted which tilts it toward the smaller companies, not just larger companies.  As you can see by the black line below, over the past year, that equal weighting tilt has resulted in even better relative strength. However, it also had a wider range (volatility) at some points. Though it doesn’t always work out this way, you are probably beginning to see how different exposures create unique return streams and risk/reward profiles.

SPDR Biotech Index ETF XBI IBB and Biogen BIIB 2015-07-29_10-35-46

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

In fact, those who have favored “stock picking” may be fascinated to see the equal-weighted  SPDR® S&P® Biotech ETF (XBI: the black line) has actually performed as good as the best stock of the top 5 largest biotech stocks in the iShares Nasdaq Biotech ETF.

SPDR Biotech vs CELG AMGN BIIB GILD REGN

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

Biotech indexes aren’t just pure biotech industry exposure. They also have exposures to the healthcare sector. For example, iShares Nasdaq Biotech shows about 80% in biotechnology and 20% in sectors categorized in other healthcare industries.

iShares Nasdaq Biotech ETF exposure allocation

Source: www.ishares.com

The brings me to another point I want to make. The broader healthcare sector also includes some biotech. For example, the iShares U.S. Healthcare ETF is one of the most traded and includes 23.22% in biotech.

iShares Healthcare Index ETF exposure allocation

Source: https://www.ishares.com/us/products/239511/IYH?referrer=tickerSearch

It’s always easy to draw charts and look at price trends retroactively in hindsight. If we only knew in advance how trends would play out in the future we could just hold only the very best. In the real world, we can only identify trends based on probability and by definition, that is never a sure thing. Only a very few of us really know what that means and have real experience and a good track record of actually doing it.

I have my own ways I aim to identify potentially profitable directional trends and my methods necessarily needs to have some level of predictive ability or I wouldn’t bother. However, in real world portfolio management, it’s the exit and risk control, not the entry, the ultimately determines the outcome. Since I focus on the exposure to risk at the individual position level and across the portfolio, it doesn’t matter so much to me how I get the exposure. But, by applying my methods to more diversified index ETFs across global markets instead of just U.S. stocks I have fewer individual downside surprises. I believe I take asset management to a new level by dynamically adapting to evolving markets. For example, they say individual selection risk can be diversified away by holding a group of holdings so I can efficiently achieve that through one ETF. However, that still leaves the sector risk of the ETF, so it requires risk management of that ETF position. They say systematic market risk can’t be diversified away, so most investors risk that is left is market risk. I manage both market risk and position risk through my risk control systems and exits. For me, risk tolerance is enforced through my exits and risk control systems.

The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted, and numbers may reflect small variances due to rounding. Standardized performance and performance data current to the most recent month end may be obtained by clicking the “Returns” tab above.

Low Volatility and Managed Volatility Smart Beta is Really Just a Shift in Sector Allocation

There is a lot of talk now days about “Smart Beta”. Smart beta refers to an investment style where the manager passively follows an index designed to take advantage of perceived systematic biases or inefficiencies in the market. Smart beta defines a set of investment strategies that emphasize the use of alternative index construction rules to traditional market capitalization based indices.

Low volatility or managed volatility, for example, is considered a version of “smart beta” because its weights the stocks (and therefore sector exposure) differently:

The PowerShares S&P 500® Low Volatility Portfolio (Fund) is based on the S&P 500®Low Volatility Index (Index). The Fund will invest at least 90% of its total assets in common stocks that comprise the Index. The Index is compiled, maintained and calculated by Standard & Poor’s and consists of the 100 stocks from the S&P 500® Index with the lowest realized volatility over the past 12 months. Volatility is a statistical measurement of the magnitude of up and down asset price fluctuations over time. The Fund and the Index are rebalanced and reconstituted quarterly in February, May, August and November.

I bolded the main difference between this index ETF and the traditional capitalization-weighted S&P 500. The S&P 500 everyone knows about weights is 500 stocks holdings based on market capitalization, so the largest stocks are the largest positions in the index.

The Low Volatility Portfolio is really a play on sector allocation. Because it creates its position size based on each stocks past 12 months volatility, it’s weighting will simply depend on what was less volatile the past year. And, it will look back to rebalance and reconstitute quarterly in February, May, August and November. So, you may consider what it really does is shifts the position size and sector weighting.

Below is the index sector allocation for the S&P 500 like what is used for SPDR® S&P 500® ETF so we can see which sectors have the largest position size.

S&P 500 SPY sector weighting

Source: https://www.spdrs.com/product/fund.seam?ticker=spy

Now we observe the sector allocation of the PowerShares S&P 500 Low Volatility Portfolio. Notice is is heavily weighted in Financials (36%) and Consumer Staples (21%). That’s simply because those sectors stocks have demonstrated less realized volatility as measured by standard deviation over the past 12 months.

PowerShares S&P 500 Low Volatility Portfolio SPLV

Source: https://www.invesco.com/portal/site/us/financial-professional/etfs/product-detail?productId=SPLV

Now, let’s observe the difference in return streams. Below is a relative strength comparison of the two since inception of  PowerShares S&P 500® Low Volatility Portfolio in May 2011. As you see, the low volatility index did have a smaller drawdown in 2011, but overall they’ve tracked the same most of the time. The real difference was the lower drawdown from the sector weighting helped reduce the loss in 2011 and that helped smooth out the returns for a few years. Since 2013 U.S. stock volatility declined, so that explains why the two indexes have trended more closely since.

S&P 500 low volatility vs capitalization

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

Over the past year, there is a little more divergence at times as we see below.

S&P 500 Low Volatility

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

You may consider that past realized volatility may not repeat into the future. In fact, it could reverse. But the real difference between these is the trailing realized volatility weighting changes the sector weighting. The sectors are the driver. Which sectors have the lowest 12 month historical volatility will determine the exposure to a volatility weighted index or fund. The risk to volatility weighting is the volatility of markets sometimes reach its lowest point at its peak in price as investors become more and more complacent and less indecisive, which is what causes a wider range in prices. I explained this in This is When MPT and VaR Get Asset Allocation and Risk Measurement Wrong.

Though the widening range of prices up and down gets our attention, it isn’t really volatility that investors want to manage so much as it is the downside loss of capital. I really manage volatility by actively increasing and decreasing exposure to loss.

What About the Stock Market Has Changed? A Look at Ten Years of Volatility

When asked to sum the Buddha’s teachings up in one phrase, Suzuki Roshi simply said, “Everything changes.”

The universe is transient, in a constant state of flux. This impermanence, that things are constantly changing and evolving, is one of the few things we can be sure about. Whatever it is today, it will evolve and eventually change. I believed this, so I embraced change and uncertainty. That led me to deeply study rates of change, magnitude of change, and probability of change.

So when I speak about volatility, I am necessarily talking about “how much it has changed”. Volatility is the range of change. If there is no volatility, there is no change. If the range is very wide, the range of outcomes is wide.

In statistics, standard deviation is a measure that is used to quantify this amount of range, variation, or dispersion of a set of data. In finance, it’s used to measure the range of prices. Many use it as a risk measure.

As of this month, I have been managing ASYMMETRY® Global Tactical as a separately managed account program for 10 years. Ten years is somewhat an arbitrary time frame, but it’s also a meaningful milestone given the range of change over this period. This past decade has been unique in that it included a range of change few have experienced or observed before. It’s really just change doing what it does.

What has changed over the past 10 years?

In A Tale of Two Conditions for U.S. and International Stocks: Before and After 2008 I pointed out the material change in the directional trends of the U.S. stock market vs. international stocks. Prior to 2008, the international stock market indexes were materially stronger trends than U.S. stocks. Since 2008, the U.S. stock market rate of change has been stronger than the global markets.

Another very significant change has been volatility. The change in volatility is critical to understand as I pointed out in This is When MPT and VaR Get Asset Allocation and Risk Measurement Wrong. Below, I will illustrate visually how volatility has changed and what it means today.

Historical standard deviation is commonly used in investment models as an input for  volatility and is often considered a measure of ‘risk”. In some ways that is true, in other ways I disagree. When prices trade in a wide range up and down, it tends to get attention. Investors start to watch it closely. If a portfolio goes up 10% and then down -10% over a period of time, it gets the investors attention. If that portfolio declines -20%, then gains 10%, then declines -15%, they may have a reaction. We call the actual decline “drawdown”, but the widening range and how fast the values move up and down is called “volatility”.

The chart below is the S&P 500 stock index (blue line) and the historical volatility as measured by standard deviation with a 1 year look-back. As you can see, historical volatility as measured by standard deviation tends to decline after the price trend rises such as 2005 to late 2007 and again starting in 2013 to now. We can also observe it increasing significantly after the stock index declined. Historical volatility stayed very high after 2008 and observing from a 1 year look-back, it remained very high until late 2013. Investors dislike volatility because it’s more difficult to hold on to a trend when its range up and down is high. If investors don’t like volatility, then you can see why they had such a hard time holding stock positions for several years.

Standard Deviation

Clearly, investors who don’t like volatility had a very difficult time holding the stock market up until recently. The past decade has shown us material changes in volatility from the low and decreasing period pre-2008 to the extreme high volatility up until late 2013. Some investors may now even be thinking of getting “more aggressive”, now that the wide price swings have become a distant memory. But you may consider that low volatility is a sign of less indecision. After prices trend up for years, investors become more complacent and therefore volatility declines. Just as we saw in 2007, we shouldn’t be surprised to see volatility very low at the price peak.

You can probably see how this is a real problem. On the one hand, if we want investors to be able to handle the volatility of a investment program, the risk and volatility necessarily needs to be managed so they don’t experience it. An active risk management system with an absolute return objective like I operate wants to have less exposure during highly volatile periods investors prefer to avoid. Yet, you may see how many investors who apply conventional asset allocation and risk measures, like Modern Portfolio Theory and Value at Risk that use standard deviation as an input, are likely to have models that get them more exposure at the peaks and less exposure at the lows. That is, at the peaks their models expected return is at its highest and its expected variance is at its lowest. After a major decline in price just the opposite is true: their expected return based on historical return is at its lowest and expected variation is the highest.

The past 10 years was a very challenging period anyway we slice it. But an investment program like ASYMMETRY® Global Tactical that avoided large drawdowns as well as avoided such radical swings, allowed investors to stick with the program and compound capital positively rather than panic out or deal with large losses and drawdowns.

The Greek philosopher Heraclitus famously said, “No same man could walk through the same river twice, as the man and the river have since changed.” I think we can be sure about only one thing: the next price trend and volatility will be different, so I embrace it and am prepared for however it unfolds.

Why So Stock Market Focused?

Most investors and their advisors seem to speak mostly about the stock market. When they mention “the market” and I ask “what market?” they always reply “the stock market”.

Why so stock market centric?

It must be that it gets the most media attention or stocks seem more exciting?. After all, other markets like bonds may seem boring and few know much about the many commodities markets or the foreign exchange markets. There are many different markets and two sides to them all.

If it’s risk-adjusted returns you want, you may be surprised to find where you should have invested your money the past 15 years. To make the point, below is a comparison of the total return of the Vanguard S&P 500 stock index (the orange line) compared to the Vanguard Bond Index (the blue line). Yes, you are seeing that correctly. Using these simple index funds as a proxy, bonds have achieved the same total return as stocks, but with significantly less volatility and drawdowns. This is why we never look at just “average” return data without considering the path it took to get there. A total return percentage gain chart like this one presents a far more telling story. Take a close look at the path they took.

stocks vs. bonds

Created with http://www.ycharts.com

I showed the chart to one investment advisor who commented “It looks like the stock market is catching up”. If that’s what you think of when you view the chart, you may have a bias blind spot: ignoring the vast difference in the risk between the two markets.

Looking at the total return over the period identifies the obvious difference in the path the two return streams took to achieve their results, but below we see the true risk difference. Drawdowns are declines from a higher value to a low value and a visual representation of how long it took to recover the lose of capital. When we observe a drawdown chart like the one below, it’s like a lake. These charts together also help illustrate the flaw of averages. The average return of the stock and bond index have ended at about the same level and have the same average return, but the bond index achieved it with much less drawdown. You wouldn’t know that if you only looked at average returns. If you tried to walk across the stock market lake, you may have drowned if you couldn’t handle swimming in 40′ of water for so long. If that one didn’t get you, the 55′ may have. The stock index declined about -40% from 2000 – 2002 and took years to recover before it declined -55%.

stock and bond market risk historical drawdowns

Created with http://www.ycharts.com

You have to be wondering: why didn’t you just invest in bonds 15 years ago? Maybe you were focused on the prior period huge average returns in stocks?

Before I continue, let me place a very bold disclaimer here: PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS. Another way that is stated is that PAST PERFORMANCE IS NO ASSURANCE OF FUTURE RESULTS. One more version is PAST PERFORMANCE MAY NOT BE AN INDICATION OF FUTURE RESULTS. If you remember, the 1990’s were a roaring bull market in stocks. People focus on the past expecting it to continue. That’s probably why you never thought to invest in bonds instead of stocks.

Some of the largest and most successful hedge funds in the world have done that very thing over this period and longer. But, they didn’t just invest in bonds. They leveraged bonds. We’ve seen in this example that a bond index fund has achieved just as much total return as stocks. If you are a stock market centric investor: one that likes the stock market and makes it your focus, then you necessarily had to be willing to endure those -40% to -55% declines and wait many years to recover from the losses. If you are really willing to accept such risk, imagine if you had used margin to leverage bonds. The bond index rarely declined -10% or more. It was generally a falling interest rate period, so bonds gained value. If you were willing to accept -40% to -55% declines in stocks, you could have instead leveraged the bonds 400% or 500%. If you had done that, your return would be 4 or 5 times more with a downside more equal to that of stocks.

Why so stock centric?

Of course, at this stage, the PAST PERFORMANCE IS HIGHLY UNLIKELY TO REPEAT INTO THE FUTURE. Just as the roaring stocks of the 1990’s didn’t repeat. To see why, read Stage and Valuation of the U.S. Stock Market and Bonds: The Final Bubble Frontier?.

From my observations of investors performance and their advisors, most people seem to have poor results the past decade or so, even after this recent bull market. An investment management consultant told me recently that investors and their advisors who are aware of the current stage of stocks and bonds feel there is no place to turn. I believe it’s a very important time to prepare to row, not sail. For me, that means focus on actively managing risk and look for potentially profitable trends across a very global universe of markets; currency, bonds, stocks, commodities, and alternatives like volatility, inverse, etc . That’s my focus in ASYMMETRY® | Managed Accounts.

The Volatility Index (VIX) is Getting Interesting Again

In the last observation I shared on the CBOE Volatlity index (the VIX) I had been pointing out last year the VIX was at a low level and then later started trending up. At that time, many volatility traders seemed to think it was going to stay low and keep going lower – I disagreed. Since then, the VIX has remained at a higher average than it had been – up until now. You can read that in VIX® gained 140%: Investors were too complacent.

Here it is again, closing at 12.45 yesterday, a relatively low level for expected volatility of the S&P 500 stocks. Investors get complacent after trends drift up, so they don’t price in so much fear in options. Below we observe a monthly view to see the bigger picture. The VIX is getting down to levels near the end of the last bull market (2007). It could go lower, but if you look closely, you’ll get my drift.

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

Next, we zoom in to the weekly chart to get a loser look.

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

Finally, the daily chart zooms in even more.

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

The observation?

Options traders have priced in low implied volatility – they expect volatility to be low over the next month. That is happening as headlines are talking about stock indexes hitting all time highs. I think it’s a sign of complacency. That’s often when things change at some point.

It also means that options premiums are generally a good deal (though that is best determined on an individual security basis). Rather than selling premium, it may be a better time to buy it.

Let’s see what happens from here…

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 Returns of World Markets YTD

As of today, global stock, bond, commodity markets are generating asymmetric returns year to date. The graph below illustrates the asymmetry is negative for those who need these markets to go “up”.

Asymmetric Returns of World Markets 2015-04-10_10-52-47

source: http://finviz.com

 

Asymmetric Nature of Losses and Loss Aversion

Loss Aversion:

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

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

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

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

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

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

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

Actually, the math agrees.

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

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

 

asymmetry impact of loss

Absolute Return: an investment objective and strategy

Absolute returns investment strategy fund

Absolute Return in its basic definition is the return that an asset achieves over a certain period of time. This measure looks at the appreciation or depreciation (expressed as a dollar amount or a percentage). For example, a $50 stock drifts to $100 is a 100% absolute return. If that same stock drifts back from $100 to $50, its absolute return is -50%.

Absolute Return as an investment objective is one that does not try to track or beat an arbitrary benchmark or index, but instead seeks to generate real profits over a complete market cycle regardless of market conditions. That is, an absolute return objective of positive returns on investment over a market cycle of both bull and bear market periods irrespective of the direction of stock, commodity, or bond markets. Since the U.S. stock market has been generally in a uptrend for 6 years now, other than the -20% decline in the middle of 2011, we’ll now have to expand our time frame for a full market cycle to a longer period. That is, a full market cycle includes both a bull and a bear market.

The investor who has an absolute return objective is concerned about his or her own objectives for total return over a period and tolerance for loss and drawdowns. That is a very different objective than the investor who just wants whatever risk and return a benchmark, allocation, or index provides. Absolute returns require skill and active management of risk and exposure to markets.

Absolute return as a strategy: absolute return is sometimes used to define an investment strategy. An absolute return strategy is a plan, method, or series of maneuvers aiming to compound capital positively and to avoid big losses to capital in difficult market conditions. Whereas Relative Return strategies typically measure their success in terms of whether they track or outperform a market benchmark or index, absolute return investment strategies aim to achieve positive returns irrespective of whether the prices of stocks, bonds, or commodities rise or fall over the market cycle.

Absolute Return Investment Manager

Whether you think of absolute return as an objective or a strategy, it is a skill-based rather than market-based. That is, the absolute return manager creates his or her results through tactical decision-making as opposed to taking what the market is giving. One can employ a wide range of approaches toward an absolute return objective, from price-based trend following to fundamental analysis. In the ASYMMETRY® Managed Accounts, I believe price-based methods are more robust and lead to a higher probability of a positive expectation. Through my historical precedence, testing, and experience, I find that any fundamental type method that is based on something other than price has the capability to stray far enough from price to put the odds against absolute returns. That is, a manager buying what he or she believes is undervalued and selling short what he believes is overvalued can go very wrong if the position is on the wrong side of the trend. But price cannot deviate from itself. Price is the judge and the jury.

To create absolute returns, I necessarily focus on absolute price direction. Not relative strength, which is a rate of change relative to another moving trend. And, I focus on actual risk, not some average risk or an equation that oversimplifies risk like standard deviation.

Of course, absolute return and the “All Weather” type portfolio sound great and seem to be what most investors want, but it requires incredible skill to execute. Most investors and advisors seem to underestimate the required skills and experience and most absolute return strategies and funds have very limited and unproven track records. There is no guarantee that these strategies and processes will produce the intended results and no guarantee that an absolute return strategy will achieve its investment objective.

For an example of the application of an absolute return objective, strategy, and return-risk profile, visit http://www.asymmetrymanagedaccounts.com/

Absolute Return as an Investment Strategy

Absolute Return Investment Strategy Fund Manager

In “Absolute Return: The Basic Definition”, I explained an absolute return is the return that an asset achieves over a certain period of time. To me, absolute return is also an investment objective.

In “Absolute Return as an Investment Objective” I explained that absolute return is an investment objective is one that does not try to track or beat an arbitrary benchmark or index, but instead seeks to generate real profits over a complete market cycle regardless of market conditions. That is, it is focused on the actual total return the investor wants to achieve and how much risk the investor will willing to take, rather than a focus on what arbitrary market indexes do.

Absolute return as a strategy: absolute return is sometimes used to define an investment strategy. An absolute return strategy is a plan, method, or series of maneuvers aiming to compound capital positively and to avoid big losses to capital in difficult market conditions. Whereas Relative Return strategies typically measure their success in terms of whether they track or outperform a market benchmark or index, absolute return investment strategies aim to achieve positive returns irrespective of whether the prices of stocks, bonds, or commodities rise or fall over the market cycle.

Whether you think of absolute return as an objective or a strategy, it is a skill-based rather than market-based. That is, the absolute return manager creates his or her results through tactical decision-making as opposed to taking what the market is giving. One can employ a wide range of approaches toward an absolute return objective, from price-based trend following to fundamental analysis. In the ASYMMETRY® Managed Accounts, I believe price-based methods are more robust and lead to a higher probability of a positive expectation. Through my historical precedence, testing, and experience, I find that any fundamental type method that is based on something other than price has the capability to stray far enough from price to put the odds against absolute returns. That is, a manager buying what he or she believes is undervalued and selling short what he believes is overvalued can go very wrong if the position is on the wrong side of the trend. But price cannot deviate from itself. Price is the judge and the jury.

Of course, absolute return and the “All Weather” type portfolio sound great and seem to be what most investors want, but it requires incredible skill to execute. Most investors and advisors seem to underestimate the required skills and experience and most absolute return strategies and funds have very limited and unproven track records. There is no guarantee that these strategies and processes will produce the intended results and no guarantee that an absolute return strategy will achieve its investment objective.

For an example of the application of an absolute return objective, strategy, and return-risk profile,  visit http://www.asymmetrymanagedaccounts.com/

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

Sectors Showing Some Divergence…

So far, U.S. sector directional price trends are showing some divergence in 2015.

Rather than all things rising, such divergence may give hints to new return drivers unfolding as well as opportunity for directional trend systems to create some asymmetry by avoiding the trends I don’t want and get exposure to those I do.

Sector ETF Divergence 2015-03-04_11-24-54

For more information about ASYMMETRY®, visit: http://www.asymmetrymanagedaccounts.com/global-tactical/

 

Chart source: http://www.finviz.com/groups.ashx

 

 

Top Traders Unplugged Interview with Mike Shell: Episode 1 & 2

Top Traders Unplugged Mike Shell ASYMMETRY Global Tactical Shell Capital Management

As I approach the 10-year milestone of managing ASYMMETRY® Global Tactical as a separately managed account, I wanted to share my recent interview with Top Traders Unplugged. Niels Kaastrup-Larsen is the host of Top Traders Unplugged in Switzerland. Niels has been in the hedge fund industry for more than twenty years, working for some of the largest hedge funds in the world. He asks a lot of outstanding questions about life and how I offer a global tactical strategy that is normally only offered in a hedged fund in a separately managed account. And with experience comes depth of knowledge, so our conversation lasted over two hours and is divided into two episodes.

Click the titles to listen.

Episode 1

Why You Don’t Want Symmetry in Investing | Mike Shell, Shell Capital Management | #71

“It’s not about trying to make all the trades a winner – it’s about having the average win be much greater than the average loss – and that is asymmetry.” – Mike Shell

Episode 2

He Adds Value to His System | Mike Shell, Shell Capital Management | #72

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

Direct links:

Episode 1

http://toptradersunplugged.com/why-you-dont-want-symmetry-in-investing-mike-shell-shell-capital-management/

iTunes: https://itunes.apple.com/us/podcast/why-you-dont-want-symmetry/id888420325?i=335354134&mt=2

Episode 2

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

iTunes: https://itunes.apple.com/us/podcast/he-adds-value-to-his-system/id888420325?i=335582098&mt=2

 

For more information, visit ASYMMETRY® Managed Accounts.

Mike Shell Interview 2 with Michael Covel on Trend Following

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

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

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

To listen, click: Mike Shell Interview with Michael Covel

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

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

 

Mike Shell Interview 2 with Michael Covel on Trend Following Radio

Top Traders Unplugged Interview with Mike Shell: Episode 2

Top Traders Unplugged Mike Shell ASYMMETRY Global Tactical Shell Capital Management

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

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

 

Direct links:

Episode 2

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

For more information, visit ASYMMETRY® Managed Accounts.

Top Traders Unplugged Interview with Mike Shell: Episode 1

“It’s not about trying to make all the trades a winner – it’s about having the average win be much greater than the average loss – and that is asymmetry.” – Mike Shell

Does anyone recognize this guy? this is the first episode of my 2 hour interview with Niels Kaastrup-Larsen in Switzerland on “Top Traders Unplugged” who has been part of the hedge fund industry for more than twenty years, working for some of the largest hedge funds in the world.

For those unsure what a “top trader” means, my 10 year performance is at the bottom of this link: http://www.asymmetrymanagedaccounts.com/global-tactical/

I encourage you to to listen to the interview as it’s as much about life as trading. You can listen directly on the website or the podcast in iTunes. click: Mike Shell Interview with Top Traders Unplugged

Top Traders Unplugged Mike Shell Capital Management Interview

This is When MPT and VaR Get Asset Allocation and Risk Measurement Wrong

I was talking to an investment analyst at an investment advisory firm about my ASYMMETRY® Managed Account and he asked me what the standard deviation was for the portfolio. I thought I would share with you and explain this is how the industry gets “asset allocation” and risk measurement and management wrong. You see, most people have poor results over a full market cycle that includes both rising and falling price trends, like global bull and bear markets, recessions, and expansions. Quantitative Analysis of Investor Behavior, SPIVA, Morningstar, and many academic papers have provided empirical evidence that most investors (including professionals) have poor results over the long periods. For example, they may earn gains in rising conditions but lose their gains when prices decline. I believe the reason is they get too aggressive at peaks and then sell in panic after losses get too large, rather than properly predefine and manage risk.

You may consider, then, to have good results over a long period, I necessarily have to believe and do things very different than most people.

On the “risk measurement” topic, I thought I would share with you a very important concept that is absolutely essential for truly actively controlling loss. The worst drawdown “is” the only risk metric that really matters. Risk is not the loss itself. Once we have a loss, it’s a loss. It’s beyond the realm of risk. Since risk is the possibility of a loss, then how often it has happened in the past and the magnitude of the historical loss is the mathematical expectation. Beyond that, we must assume it could be even worse some day. For example, if the S&P 500 stock index price decline was -56% from 2007 to 2009, then we should expect -56% is the loss potential (or worse). When something has happened before, it suggests it is possible again, and we may have not yet observed the worst decline in the past that we will see in the future.

The use of standard deviation is one of the very serious flaws of investors attempting to measure, direct, and control risk. The problem with standard deviation is that the equation was intentionally created to simplify data. The way it is used draws a straight line through a group of data points, which necessarily ignores how far the data really spreads out. That is, standard deviation is intended to measure how far the data spreads out, but it actually fails to absolutely highlight the true high point and low point. Instead, it’s more of an average of those points. Yet, it’s the worst-case loss that we really need to focus on. I believe in order to direct and control risk, I must focus on “how bad can it really get”. Not just “on average” how bad it can get. The risk in any investment position is at least how much it has declined in the past. And realizing it could be even worse some day. Standard deviation fails to reflect that in the way it is used.

Consider that as prices trend up for years, investors become more and more complacent. As investors become complacent, they also become less indecisive as they believe the recent past upward trend will continue, making them feel more confident. On the other hand, when investors feel unsure about the future, their fear and indecisiveness is reflected as volatility as the price churns up and down more. We are always unsure about the future, but investors feel more confident the past will continue after trends have been rising and volatility gets lower and lower. That is what a peak of a market looks like. As it turns out, that’s just when asset allocation models like Modern Portfolio Theory (MPT) and portfolio risk measures like Value at Risk (VaR) tell them to invest more in that market – right as it reaches it’s peak. They invest more, complacently, because their allocation model and risk measures tell them to. An example of a period like this was October 2007 as global stock markets had been rising since 2003. At that peak, the standard deviation was low and the historical return was at it highest point, so their expected return was high and their expected risk (improperly measured as historical volatility) was low. Volatility reverses the other way at some point

What happens next is that the market eventually peaks and then begins to decline. At the lowest point of the decline, like March 2009, the global stock markets had declined over -50%. My expertise is directional price trends and volatility, so I can tell you from empirical observation that prices drift up slowly, but crash down quickly. The below chart of the S&P 500 is a fine example of this asymmetric risk.

stock index asymmetric distribution and losses

Source: chart is drawn by Mike Shell using http://www.stockcharts.com

At the lowest point after prices had fallen over -50%, in March 2009, the standard deviation was dramatically higher than it was in 2007 after prices had been drifting up. At the lowest point, volatility is very high and past return is very low, telling MPT and VaR to invest less in that asset.

In the 2008 – 2009 declining global markets, you may recall some advisors calling it a “6 sigma event”. That’s because the market index losses were much larger than predicted by standard deviation. For example, if an advisors growth allocation had an average return of 10% in 2007 based on its past returns looking back from the peak and a standard deviation of 12% expected volatility, they only expected the portfolio would decline -26% (3 standard deviations) within a 99.7% confidence level – but the allocation actually lost -40 or -50%. Even if that advisor properly informed his or her client the allocation could decline -26% worse case and the client provided informed consent and acceptance of that risk, their loss was likely much greater than their risk tolerance. When the reach their risk tolerance, they “tap out”. Once they tap out, when do they ever get back in? do they feel better after it falls another -20%? or after it rises 20%? There is no good answer. I want to avoid that situation.

You can see in the chart below, 3 standard deviations is supposed to capture 99.7% of all of the data if the data is a normal distribution. The trouble is, market returns are not a normal distribution. Instead, their gains and losses present an asymmetrical return distribution. Market returns experience much larger gains and losses than expected from a normal distribution – the outliers are critical. However, those outliers don’t occur very often: maybe every 4 or 5 years, so people have time to forget about the last one and become complacent.

symmetry normal distribution bell curve black

Source: http://en.wikipedia.org/wiki/68%E2%80%9395%E2%80%9399.7_rule

My friends, this is where traditional asset allocation like Modern Portfolio Theory (MPT) and risk measures like Value at Risk (VaR) get it wrong. And those methods are the most widely believed and used . You can probably see why most investors do poorly and only a very few do well – an anomaly.

I can tell you that I measure risk by how much I can lose and I control my risk by predefining my absolute risk at the point of entry and my exit point evolves as the positions are held. That is an absolute price point, not some equation that intentionally ignores the outlier losses.

As the stock indexes have now been overall trending up for 5 years and 9 months, the trend is aged. In fact, according to my friend Ed Easterling at Crestmont Research, at around 27 times EPS the stock index seems to be in the range of overvalued. In his latest report, he says:

“The stock market surged over the past quarter, adding to gains during 2014 that far exceed underlying economic growth. As a result, normalized P/E increased to 27.2—well above the levels justified by low inflation and interest rates. The current status is approaching “significantly overvalued.”

At the same time, we shouldn’t be surprised to eventually see rising interest rates drive down bond values at some point. It seems from this starting point that simply allocating to stocks and bonds doesn’t have an attractive expected return. I believe a different strategy is needed, especially form this point forward.

In ASYMMETRY® Global Tactical, I actively manage risk and shift between markets to find profitable directional price trends rather than just allocate to them. For more information, visit http://www.asymmetrymanagedaccounts.com/global-tactical/

 

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.

 

 

Volatility Risk Premium

Following up from “VIX Back to Low” I wrote last week, sure enough: the volatility index has gained 20%. Since last week it has been a good time to be long volatility and a bad time to be short volatility. Many professionals who trade volatility as their primary strategy mostly sell it to collect the Volatility Risk Premium. To do that, they have to be willing to experience gaps like this.

VIX CBOE VOLATILTY INDEX JULY

 

The VIX is Asymmetric, making its derivatives an interesting hedge

Asymmetric payoff VIX

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

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

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

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

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

 

The VIX is Asymmetric

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

 

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

The VIX, as I see it…

The CBOE Volatility Index (VIX) reached a low point last week not seen since 2007 as evidenced by the chart below.

CBOE VOLATILITY INDEX HISTORY

To see a closer view of the last period, below I included the last time the VIX was at such a low value. I show this to point out that the VIX oscillated between 9% and 12% for about 4 months before it finally spiked up to 20. Such a trend reversal (or mean reversion if you prefer) can take time. Imagine if the VIX stays this low for the next 4 months before a spike. Or, it could happen very soon. You may notice the VIX reached the level it is now at its lowest level in early 2007. If we believed these trends repeat perfectly, that absolute level would matter. Trends are more like snowflakes: no two are exactly the same. But in relative terms, the fact that today’s level is as low as the lowest point in early 2007 is meaningful if you care about the risk level in stocks and the stage of the market cycle.

CBOE VOLATILITY INDEX VIX Low levels

The best way to examine a trend is to zoom in. Start with a broader view to see the big picture, then zoom in closer and closer. When people focus too much on the short-term, they miss the forest for the trees. Below is the last time the VIX was below 12. You may notice that is does oscillate up and down in a range.

VIX BELOW 12

The level and directional trend of the VIX matters because of the next chart. You may see a trend if you look closely. The black line is the S&P 500 stock index. The black and red line is the VIX CBOE Volatility Index. You may notice the two tend to drift in opposite directions. Not necessarily on a daily basis, but overall they are “negatively correlated”. When the stock index is rising, the volatility is often falling or already at a low level. When the stock index is falling, volatility rises sharply. It isn’t a perfect opposite, but it’s there.

VIX and S&P 500 correlation and trend

If you are interested in stock trends and the trend in volatility, and specifically the current state of those cycles,  you may want to follow along in the coming days. I plan to publish a series on this topic about the VIX, as I see it. Over the last week or so I have written several ideas that I intended to publish as one large piece. Since I haven’t had time to tie it together that way, I thought I would instead publish a series.

When a trend reaches an extreme level like this, it may be useful to spend some time with it.

Stay tuned…

if you haven’t already, you may want to click on “Follow” to the right to get updates by email to follow along. This will likely be several informal notes in the coming days.

 

 

 

 

Leading stocks are lagging

As another example of the observation I pointed out in Adapting to Change… and Volatility, below are today’s stock index price changes.

stock market losses 2014-04-04_15-15-53

Below are the price changes for the top 10 highest ranked stocks. Clearly, leading stocks are dropping more. And, such an increase in volatility is more common now days.

ibd 50 top ten losses 2014-04-04_15-15-31