Extreme Low Volatility Leads to Volatility Spike

Extreme Low Volatility Leads to Volatility Spike

Posted on October 15, 2018
Featured Video:
This week’s video discusses Canterbury’s Market and Security States.  Liquid-traded securities go through different environments- bull, transitional, or bear.  Canterbury utilizes a proprietary combination of technical indicators to identify the various market environments and determine the risk of the market. 

Market State 6: Short-Term/Transitional/Long-Term Bullish (3 trading days): Market State 6 is a “Transitional” environment. Currently, the long-term algorithms are positive, short-term volatility is negative and short-term technical indicators are negative but oversold. A kick back rally is likely.
Canterbury Portfolio Analytic studies show that it was extremely rare for an outlier day to lead directly to a bear market or a bearish Market State. A shift to a bear market, from a low volatile bull, requires a process where the outlier is followed by expanding daily volatility over a period of time, typically several months. Market State 1 tends to be in place at or near a new high or has had an extended period with no meaningful correction. For example: Earlier this year, on February 2nd, 2018, the market environment shifted from “Bullish” Market State 1 to “Transitional” Market State 6. Please note, we had been in Market State 1 for 31 days until today.

When the Market State shifts from one of the 5 “Bullish” Market States to “Transitional” Market State 6, we found that 74% of the shifts to Market State 6 went back to one of the “Bullish” Market States. The transitional market environment only shifted to a new “Bearish” Market State 26% of the time.

Canterbury Volatility Index (CVI 66): The one-day outlier, down -3.3% on Wednesday, spiked the volatility from CVI 38 to CVI 59 for a 21point increase. A second one day outlier, -2.2%, occurred the next day (Thursday) pushing volatility up another 5 points to CVI 64.
Canterbury’s volatility reading will automatically turn negative when the CVI spikes by 7 points or more. It will turn back positive if volatility remains below CVI 75 and the short-term technical indicators turn back positive.
Periods of extremely low volatility almost always end the same way: with one or two big one-day outliers that occur when most would least expect. When the trading range gets really… really tight, and it stays tight for an extended period of time, it can be like shooting someone out of a spring-loaded cannon. The problem is that you are never sure when it is going to shoot or how far.
Two, back to back, outliers are not uncommon, when following a period with extremely low volatility. The first day shocked the market. The second day typically has a wide trading range because there is no point of reference as to where it should be trading. For example, the S&P 500 traded, up and down, within about a 3% trading range last Thursday. The market closed at 4:00 and just happened to be down 2% at that time. It was actually up a little earlier.

Obviously, the current market is highly emotional. One would expect a kick-back rally from here but the next few days will be unpredictable. That said, all this movement stills falls within the realm of market noise. The probability of this turning into a meaningful decline, or a new bear market, is extremely low based on our studies of similar examples in history.

Canterbury Analytics conducted a study that used daily trading data going back to 1896 (about 33,000 trading days).  Extreme low volatility periods, as defined as days at or below CVI 45, only occur about 15% of the days.  These periods of “extreme low volatility” can last for just a few days or for years at time, 29 periods ended with volatility spikes downward.  Of these periods, only 5 went into bear markets.  The other 25 mostly went into transitional Market State 6,usually for just a few weeks.  Based on this data, and some other factors, the probabilities would favor of moving back to a bullish Market State as opposed to a bear market.
Bottom Line:
The pressure, from extremely low volatility, has now officially been released. The sleepy market has been hit in the face with a cold glass of water. Right now, the market doesn’t know where it is, or where it is supposed to be. It will take a few days to shake out and get back to normal market behavior. Surprisingly, most outliers are quickly followed by normal market behavior as if nothing had happened. Other times, an additional outlier will occur before the market settles down.

This is why it is important to have an adaptive portfolio strategy, like the Canterbury Portfolio Thermostat.  Markets go through various phases and environments and it is extremely important to navigate those environments effectively.  The Canterbury Portfolio Thermostat process is designed to handle any market environment- Bull or Bear.
Canterbury Investment Management: Tom Hardin

More About Tom Hardin

As Chief Investment Officer, Tom has more than 30 years of experience in the investment management industry and has a broad breadth of knowledge. He is known as an innovator, educator and has been revolutionary in the advancements of portfolio and risk management.

Every effort was used to provide accurate data and mathematical calculations to provide, what we believe to be, accurate results. Canterbury Investment Management, LLC, and its principal owners, make no guarantee of completeness or accuracy of data or calculations as well as conclusions of any statistical data or information contained in the simulation illustrated on this page. Past results or performance is in no way a guarantee of future results.