Tag Archives: etfs

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.

When To Double Down

Here is a recent question that I got from a reader: I have a question for you that I don’t think you’ve addressed in your blog. Do you ever double down on something that has dropped significantly beyond portfolio rule VII’s rebalancing requirements and you see no reason to doubt your original thesis? Or do you almost always stick to rule VII? Just curious. Portfolio rule seven is: Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes. This rule is meant to control arrogance and encourage patience. I learned this lesson the hard way when I was younger, and I would double down on investments that had fallen significantly in value. It was never in hopes of getting the whole position back to even, but that the incremental money had better odds of succeeding than other potential uses of the money. Well, that would be true if your thesis is right, against a market that genuinely does not understand. It also requires that you have the patience to hold the position through the decline. When I was younger, I was less cautious, and so by doubling down in situations where I did not do my homework well enough, I lost a decent amount of money. If you want to read those stories, they are found in my Learning from the Past series. Now, since I set up the eight rules, I have doubled down maybe 5-6 times over the last 15 years. In other words, I haven’t done it often. I turn a single-weight stock into a double-weight stock if I know: The position is utterly safe, it can’t go broke The valuation is stupid cheap I have a distinct edge in understanding the company, and after significant review, I conclude that I can’t lose Each of those 5-6 times I have made significant money, with no losers. You might ask, “Well, why not do that only, and all the time?” I would be in cash most of the time, then. I make decent money on the rest of my stocks as well on average. The distinct edge usually falls into the bucket of the market sells off an entire industry, not realizing there are some stocks in the industry that aren’t subject to much of the risk in question. It could be as simple as refiners getting sold off when oil prices fall, even though they aren’t affected much by oil prices. Or, it could be knowing which insurance companies are safe in the midst of a crisis. Regardless, it has to be a big edge, and a big valuation gap, and safe. The Sense of Rule Seven Rule Seven has been the rule that has most protected the downside of my portfolio while enhancing the upside. The two major reasons for this is that a falling stock triggers a thorough review, and that if I do add to my position, I do so in a moderate and measured way, and not out of any emotion. It’s a business, it is not a gamble per se. As a result, I have had very few major losses since implementing the portfolio rules. I probably have one more article to add to the “Learning from the Past Series,” and the number of severe losses over the past 15 years is around a half dozen out of 200+ stocks that I invested in. Summary Doubling down is too bold of a strategy, and too prone for abuse. It should only be done when the investor has a large edge, cheap valuation, and safety. Rule Seven allows for moderate purchases under ordinary conditions and leads to risk reductions when position reviews highlight errors. If errors are eliminated, Rule Seven will boost returns over time in a modest way, and reduce risk as well. Disclosure: None

Falling Prices Are Good, Unless You Are An Imminent Seller

When the stock market is tanking, like it has been recently, I find many people are scared to talk to me about it. They seem to think that declining stock prices are like a death in the family – a reason to offer condolences. But, why is that? I don’t fret if I go to the grocery store and find prices have fallen 20%. When I go to buy gas, I’m quite happy to find prices have fallen. Why is this so different with stock prices? After all, I’m a net buyer of investments. Only if I had some imminent plan to sell my stocks because I needed the money very soon would falling prices be a bad thing. I think most people think I’m putting on a brave face or bucking myself up when I say I’m happy to see stock prices falling. They can’t seem to conceive that falling prices are good for buyers of stocks just as it is good for buyers of groceries, gas, cars or even houses. I think that is because people too closely associate themselves with their current net worth. Instead of conceiving of their net worth as something in flux, that goes up and down like everything in the economy, they feel their current net worth indicates how much they can pull over time. But, current net worth is a snapshot, not life itself. Just as a picture cannot capture a life, neither can current net worth define your lifetime cash flow. Even for those close to or in retirement, stock market fluctuations need not be of major concern. If you have money you need to spend next month or next year in the stock market, you are indeed at risk. But you need not bear that risk unless you choose to. Your cash needs for the next three or so years should be in a stable value position, like a bank or money market account, not in the stock market. Most people who fret over stock market returns don’t need that money soon, either. They know they will need it in time, but they don’t need it today. Market volatility and declines are a benefit to the calm investor who knows that current net worth is just a snapshot. Thought of in this way, stock market drops can lead to higher net worth over time and increased cash flows. That is why I’m happy to see the stock market decline, and I think others should be, too.