Monday's Spike in Volatility was Expected

Monday's Spike in Volatility was Expected

Posted on January 30, 2020
Market State 2 (Bullish): The S&P 500 currently remains in a bullish Market State, following Monday’s outlier day (-1.57%).  Over the last few weeks, the market has seen a large gain in just a short amount of time.  The market was going a little bit too far, too fast.  That being said, markets will not go from bullish to bearish overnight.  A change in market environment, from bullish to bearish, requires a process. In other words, there is no reason to be worried about one outlier day. 

Canterbury Volatility Index (CVI)-CVI 49:  As of Monday’s close, volatility jumped out of extreme low territory. Volatility had previously fallen into extreme low territory (below Canterbury Volatility Index 45).  With Monday’s outlier, we did see a spike in volatility, although not large enough to trigger what Canterbury calls a “velocity of volatility spike,” which would be triggered by a 7 point or greater jump in volatility (CVI only went from 44 to 49). 

Oftentimes, it is common to see multiple outliers clumped together.  Monday’s downside outlier day was followed by a 1.00% gain on Tuesday.  Most volatility spikes coming out of extreme low volatility environments usually stabilize out.  Again, to reiterate what was said in the previous section, markets do not go from bull to bear overnight.  Markets typically don’t go from an extreme low volatility environment straight into a highly volatile one. 

Monday’s market outlier is the result of extreme low volatility, coupled with an upward, parabolic move in the markets that could not be sustained.  If we do see a pullback or small correction from here, it would be very normal.  The Nasdaq is still outperforming the S&P 500 (positive sign) and most stocks have been participating in the recent rally, rather than just the larger S&P components (positive sign).

Rotation is law in the markets.  Sectors, industries, and all asset classes will have times of being in favor and times of being out of favor.  They will also have times of relative outperformance and relative underperformance.  If we take a look at the S&P 500’s 11 sectors over a short timeframe, we can see that there has been some shift in leadership over the time of this extended run in the S&P 500.

Below is a table showing the sector rankings at three different points: December 1st (2019), January 2nd (2020), and Monday (January 27, 2020). The sectors are ranked according to their Volatility-Weighted-Relative-Strength, which is a risk-adjusted ranking, where each sector’s strength is adjusted for its level of volatility.
VWRS Rank December 1st, 2019 January 2nd, 2020 January 27, 2020
1 Technology Technology Technology
2 Healthcare Healthcare Utilities
3 Financials Financials Healthcare
4 Industrials Staples Communications
5 Communications Utilities Staples
6 Staples Communications Industrials
7 Materials Materials Discretionary
8 Utilities Discretionary Financials
9 Discretionary Industrials Real Estate
10 Real Estate Real Estate Materials
11 Energy Energy Energy
One thing to point out from this table is the rise in Utilities.  Utilities started out in 8th to begin the month of December but rose to the 2nd best ranked sector.  This all occurred during a parabolic advance in the S&P 500, which is counterintuitive.  One would not really expect for utilities to rise in rankings during a rising market, but on a risk-adjusted basis, it did.  Most other sectors maintained their same basic position.  Financials has slipped due to flattening out over the last two weeks. 

As an important note, every sector aside from Energy and Materials is in a bullish Market State.  Energy is Market State 12 and Materials is in Market State 6.  Bullish Market States are categorized as having low risk.  Most sectors have been performing well, and with low volatility.  In fact, Energy has the highest volatility (ranked last), but Technology has the second highest volatility (ranked first).  What this means is that even though technology has the second highest level of volatility, its volatility is still low, like most sectors, and has bullish characteristics. 

Bottom Line
Monday was an outlier day (beyond +/-1.50%) and volatility rose slightly.  We have discussed that this could be a possibility given that CVI was extremely low and the market has seen a parabolic advance.  There are many positive signs in the markets, such as the Nasdaq outperforming and breadth indicators showing that many stocks have participated in the recent rally.  Given the markets movement upward, a small pullback is required at some point to continue.  Most sectors remain in bullish Market States and still have low volatility.

Canterbury will continue to monitor the markets for any further increases in volatility or changes in Market State.  The Portfolio Thermostat continuously monitors its internal holdings and portfolio metrics (volatility level, benefit of diversification) in order to maintain an efficient portfolio through all market environments- Bull or Bear.