Tag Archives: market

Is The Bull Market About To End?

Summary Volatility spikes in the absence of systemic risk could offer higher future returns. The current environment is not similar to 2008. Forecasted volatility isn’t high compared to history. A rate hike by the Fed could significantly increase volatility. In our last update , we pointed out the risks in the emerging markets. That theme has continued to play out. By now, investors would’ve experienced maximum losses of -44% in China and -32% in EM equities. US equities are still doing better than other markets – currently at -12% maximum loss. In this environment, every online robo-advisor is telling their investors to keep calm and carry on. We here at Cassia prefer to be more proactive when it comes to managing risk. We have been performing emergency rebalances in all of our client accounts since August 22. And we continue to monitor the situation in real-time to ensure accounts can move quickly as new data comes in. Quantifying the risk The best decisions are data driven. So what is the data telling us about the current markets? Let’s talk about risk. No, I’m not talking about the flawed risk measures that everyone can calculate in Excel. I’m talking about a GARCH volatility forecast that accounts for nuances like clustering and mean reversion that we wrote about in our white paper . Typically, the S&P 500 has a volatility of 12%. In October 2008, it had a forecasted volatility of 51%. Today, our advanced risk forecasting system sees short-term volatility at 18% and 3-month volatility at 13%. This tells us two things about US Equities. The current level of volatility isn’t crazy high by historical standards. The forecasted volatility in the short-term is higher than the long-term (i.e. backwardation). Volatility spike – what does it mean? The second point warrants some investigation. So we ranked the volatility forecasts into four buckets (quartiles). We ask ourselves: “how volatile is the market relative to the long-term volatility?” Do spikes in the short-term volatility have any implications for future returns? Lo and behold. During the bull market from 2009 to present, the market appears to yield higher returns after volatility spikes. Q4 represents the days where the volatility is the highest, and Q1 represents volatility being the lowest, relative to forecasted long-term volatility. The results hold for returns 1, 5, 10, 20, 60 days into the future. This makes intuitive sense because volatility spikes tend to coincide with short-term lows in the market. Buying the dips tend to yield higher returns – in a normal environment. But look what happens when we include the highly abnormal period of 2008. Buying when volatility spikes becomes a terrible idea. Instead of yielding a higher return, buying the dips in a financial crisis, yields negative returns. Another 2008? Let’s look at systemic risk So the key question now is. Is this a 2008 environment or not? Rising correlation could indicate contagion between markets, indicating increased systemic risk and potentially a 2008 environment. Here’s what the data says as of the end of August 2015. The chart on the left shows the correlation between the S&P 500 and other major asset classes such as real estate, bonds, commodities, and emerging equities. Do you see any signs of an increase in correlation? Correlation (click to enlarge) Standardized Change (click to enlarge) We don’t. The current environment does not look similar to 2008. To make it easier to see, the chart on the right is the standardized change. If anything, the correlation between equities and other assets is experiencing the largest drop in 10 years – by almost 2 standard deviations! In contrast, correlation increased by 1.5 standard deviations at the start of 2008. For robustness, we also consulted another measure of systemic risk called the Absorption Ratio and ran it on 9 US sector funds (Kritzman 2010). The authors note that a +1 standard deviation increase in the Absorption Ratio is an indication of increased systemic risk. The current reading is at -1 standard deviation, nowhere close to systemic risk territory. Absorption Ratio (click to enlarge) Standardized Change (click to enlarge) We also repeated our test on days where systemic risk is heightened (absorption ratio greater than +1 SD). Our findings are consistent. In periods where volatility spikes are accompanied with heightened systemic risk, future 1-month returns tend to be low. And future returns are high after volatility spikes during normal periods (absorption ratio below +1 SD). GARCH volatility term structure vs. next month return (annualized) Volatility spikes during increased systemic risk: 0% Volatility spikes during normal periods: 38% Conclusion The data suggests that a) the current environment is not similar to 2008, b) forecasted volatility isn’t high compared to history, and c) volatility spikes in the absence of systemic risk have historically offered higher future returns. What can change this? We would put a September rate hike by the Fed at the top of the list. Based on the current data, we feel that there’s no overwhelming case to scale back on equities allocation. Should forecasted volatility or correlation increase dramatically, Cassia’s systems stand ready to step in and adjust allocations for its clients, faster than a human manager can react. References Kritzman, M., Li, Y., Page, S., & Rigobon, R. (2010). Principal components as a measure of systemic risk. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

The Market Peak Is In

Summary In April I wrote an article that predicted the conditions necessary for a market peak to have occurred. In August these conditions were met. I detail some investment options to consider if a peak has in fact been made. In this article, I will be explaining why I believe the market has peaked or will peak soon, which means this bull run is over. In an article I wrote in April titled ” Constructing A Market Peak Blueprint ” I detailed three metrics that when combined have predicted the end of the previous two market tops in 2000 and 2007. The metrics I looked at were the monthly S&P 500 (NYSEARCA: SPY ) Shiller PE ratio, high-yield bond spreads and interest rates. In the final paragraph, I noted, “While none of these metrics currently are near a point at which all three will align to predict a top, it is still something that investors can watch for in the future. Well, the future I talked about in my article is now! I never like being the bearer of bad news, however since I wrote my article, all three metrics have aligned to the specifications I laid out in my article. That is why I am predicting the market peak is in. Market Peak Conditions The conditions needed to be met to declare a market peak are the following conditions listed below. I collected Shiller PE data from Multipl.com , High-Yield Spread data from the St.Louis Federal Reserve and historical interest rate data from Yahoo Finance . [Note all data is monthly] As the data in the tables below show that in August, all of these conditions were met. Shiller PE of greater than 25 Shiller PE declines 4 Months in a row High Yield Spreads Increase 4 Months in a row 10-year Interest Rate decreases 3 Months in a row Shiller PE High Yield Spreads 10-Year Interest Rate May 26.87 May 4.51 May 2.10 June 26.62 June 4.66 June 2.34 July 26.55 July 5.11 July 2.21 August 26.54 August 5.66 August 2.20 Previous Peaks There have been three previous times in the last fifteen years where these conditions have all aligned and those were in November & December 2000 and August 2007. This can be seen graphically in the following two monthly charts, which show the point at which the conditions were triggered. (click to enlarge) (click to enlarge) [Charts from ThinkorSwim Platform] What can investors do? -Don’t Panic! The number one thing is not to panic if the market peak is in. I am in no way saying to go out and panic selling. However, as I detail below, there are some investment actions investors can make to lessen the pain if a market peak has already occurred and a major correction follows. Investment Option #1: Get Defensive With ETFs, investors have a number of choices that are quality ETFs that own defensive equities. The PowerShares S&P 500 Low Volatility Portfolio ETF (NYSEARCA: SPLV ) is attractive because it holds stocks with the lowest volatility in the S&P 500. The Guggenheim Defensive Equity ETF (NYSEARCA: DEF ) is attractive because it holds fundamentally strong, dividend paying companies that have a history of outperforming according to its Fact Sheet . “DEF uses a rules-based quantitative approach, the index selects stocks based on fundamental characteristics such as a strong balance sheet, dividend payments, conservative accounting practices, and a recent history of out-performance during weak market days.” The Barclays ETN+ VEQTOR S&P 500 Linked ETN (NYSEARCA: VQT ) or the PowerShares S&P 500 Downside Hedged Portfolio ETF (NYSEARCA: PHDG ), which both dynamically allocate between stocks, VIX futures & cash. The following chart from the VQT prospectus shows that in late 2008, the allocation to volatility was increased which is shown by the steep increase in the index value. [Chart from VQT Prospectus] Investment Option #2: Add a short position to hedge downside risk The two main options for shorting the overall market are the ProShares Short S&P 500 ETF (NYSEARCA: SH ), which is the DAILY inverse of the S&P 500. The second option is the AdvisorShares Ranger Equity Bear ETF (NYSEARCA: HDGE ), which is an actively managed short ETF. Investment Option #3: Consider Adding Precious Metals During the large decline in the market two weeks ago, gold (NYSEARCA: GLD ) & silver (NYSEARCA: SLV ) performed quite well because of investors seeking safety. For those looking for investment choices in the precious metals space there is obviously the GLD or SLV or there is the broad ETFS Physical Precious Metal Basket Trust ETF (NYSEARCA: GLTR ), which holds physical gold, silver, platinum & palladium. Investment Option #4: Employ a barbell approach Investors can employ a barbell approach where they own short-term fixed income to preserve capital and generate some income and high quality growth stocks. The PIMCO Enhanced Short Maturity Strategy ETF (NYSEARCA: MINT ) is an actively managed ultra-short term bond ETF designed to generate above money market returns and is a good capital preservation tool. In addition, if you still want capital preservation but are looking for a higher yield, a quality choice is the Vanguard Short-Term Corporate Bond Index ETF (NASDAQ: VCSH ), which invests in short-term investment grade corporate bonds and currently yields just less than 1.90%. For the other end of the barbell, investors can look for high growth companies that have growth and have minimal debt. For example, earlier this year I wrote an article , where I determined it was the number one stock in the world was Visa (NYSE: V ). I determined Visa was the number one stock because they have $4.7 billion in cash, no-debt, they pay a dividend, is expected to grow earnings 17.74% over the long-term, is buying back shares and in 2016 they start their new deal replacing AMEX (NYSE: AXP ) at Costco (NASDAQ: COST ). Other quality stocks like Gilead Sciences (NASDAQ: GILD ), which have strong balance sheets and clear growth drivers, should be considered when using the barbell approach. Closing Thoughts If a market peak is in fact in, investors need to be mindful and give extra scrutiny to investments for their potential performance during a down market. If a market peak has occurred, as I highly suspect that it has, individual stock selection and/or tactical allocation to ETFs is something that will become extremely important. This kind of environment is where great investors shine. I do not know who said the following quote but it applies to this situation and it goes something like “Anyone can be a good investor in a bull market, however, what separates good investors from great investors is bear market performance.” Disclaimer: See here . Disclosure: I am/we are long SPLV, GILD. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Plan And Act, Don’t React

An investor can and should learn from the past. He should never react to the recent past. Why? The past can’t be changed, but it can be known. Reacting to the recent past leads investors into the valleys of greed and regret – good investments missed, bad investments incurred. We’ve been in a relatively volatile environment for the last two weeks or so. Markets are down, with a lot of noise over China, and slowing global growth. Boo! The markets were too complacent for too long, and valuations were/are higher than they should be, given current earnings, growth prospects and corporate bond yields. It’s not the best environment for stocks given those longer-term valuation factors, but guess what? The market often ignores those until a crisis hits. The FOMC is going to tighten monetary policy soon. Boo! The things that people are taking on as worries rarely produce large crises. They could mark stocks down 20-30% from the peak, producing a bear market, but they are unlikely of themselves to produce something similar to 2000-2 or 2008-9. Let’s think about a few things supporting valuations and suppressing yields at present. The overarching demographic trend in the market leads to a fairly consistent bid for risky assets. It would take a lot to derail that bid, though that has happened twice in the last 15 years. Ask yourself, do we face some significant imbalance where the banks could be impaired? I don’t see it at present. Is a major sector like information technology or healthcare dramatically overvalued? Maybe a little overvalued, but not a lot in relative terms. There are major elections coming up next year, and a group of politicians harmful to the market will be elected. This is a bad part of the Presidential Cycle. Boo! Take a step back, and ask how you would want your portfolio positioned for a moderate pullback, where you can’t predict how long it will take or last. Also ask how you would like to be positioned for the market to return to its recent highs over the next year. Come up with your own estimates of likelihood for these scenarios, and others that you might imagine. We work in a fog. We don’t know the future at all, but we can take actions to affect it, and our investing results. The trouble is, we can adjust our risk profile, but our ability to know when it is wise to take more or less risk is poor, except perhaps at market extremes. Even then, we don’t act, because we drink the Kool-aid in those ebullient or depressed environments. We often know what we should do at the extremes, but we don’t listen. There is a failure of the will. This is a bad season of the year. September and October are particularly bad months. Boo! I often say that there is always enough time to panic. Well, let me modify that: there’s also always enough time to plan. But what will you take as inputs to your plan? Look at your time horizon, and ask what investment factors will persistently change over that horizon. There are factors that will change, but can you see any that are significant enough for you to notice, and obscure enough that much of the rest of the market has missed it? Yeah, that’s tough to do. So perhaps be modest in your risk positioning, and invest with a margin of safety for the intermediate-to-long term, recognizing that in most cases, the worst-case scenario does not persist. The Great Depression ended. So did the 70s. Valuations are higher now than in 2007. (Tsst… Boo!) The crisis in 2008-9 did not persist. That doesn’t mean a crisis could not persist, just that it is unlikely. Capitalist systems are very good at dealing with economic volatility, even amid moderate socialism. Go ahead and ask, “Will we become like Greece? Argentina? Venezuela? Russia? Spain? Etc.?” Boo! It would take a lot to get us to the economic conditions of any of those places. Thus, I would say it is reasonable to take moderate risk in this environment if your time horizon and stomach/sleep allow for it. That doesn’t mean you won’t go through a bear market in the future, but it will be unlikely for that bear market to last beyond two years, and even less likely a decade. Disclosure: None.