One Day Outliers Occur When Volatility is Extremely Low

One Day Outliers Occur When Volatility is Extremely Low

Posted on August 15, 2017
Macro- Market State (Based on the S&P 500)

Market State 2- Bullish/Rational (2 trading days):  The S&P 500 was down 36 points -1.4% while the Dow dropped 234 points -1.1% for the week. The S&P 500 was down -1.5% last Thursday which was enough to move the Portfolio Thermostat from Market State 1 to Market State 2. The total decline from the highest peak (August 7th high at 2481) to the lowest trough (2428 August 10th) was -2.13%.

Canterbury Volatility Index (CVI 35):  The market’s volatility, as measured by the CVI, was up 3 points for the week, but that wasn’t the whole story. Last Wednesday, the CVI 30 broke below the lowest volatility reading on record, which was set on January 7, 1994 at CVI 32.

Extreme Low Volatility – Observations:
Quote from last week’s update:
“The S&P 500 matched its previous CVI low for the year at 32.  As has been stated before, when volatility is exceedingly low, the market is prone to have spikes in volatility. Earlier this year, when CVI was at this same current level, the market experienced a one day pop in volatility and an outlier return day (return outside of +/- 1.50%).” 
Quote from July 31 ,2016
Bottom Line:
The low volatility will most likely relieve itself by experiencing one or two outlier trading days up or down, in the 1.5% plus range. Such days have little impact on the overall market environment.
Last Thursday’s decline of -1.5% on the S&P 500 was in line with last week’s Canterbury Update that called for a single day outlier. It probably came as a surprise to most investors who have become accustomed to a boring market environment with very little movement.
Canterbury’s studies show that outliers, like last Thursday’s, are normal and expected during times of extreme low volatility. The analogy for this move would be the squeezing down of a spring.  As market movement compresses, it can be expected that there will eventually be a one day “pop” either upward or downward.  The typical one day outlier is usually followed by a flat day, similar to the days that preceded the outlier. In other words, a one day large move will seem to come out of nowhere and then is followed by a normal trading day, as if nothing had happened the day before.
There is no such thing as a “Bearish Market Environment” with low volatility. In fact, low volatility is the primary characteristic of an efficiently traded market environment. An efficient market, or an efficient portfolio, is one that has experienced reduced risk resulting from the “benefit of diversification” among securities held.
We remain in a low risk environment. The NASDAQ 100 continues to outperform the S&P 500, which is a bullish indicator. Here is an interesting observation. Many are aware of the nine U.S. size and style boxes that are illustrated like one side of a Rubik’s cube. Of the nine styles, three are down year to date through Friday (mid-cap value, small-cap growth and small-cap value). The other styles have small gains with exception of large-cap growth. The point is that this year’s market environment has been marked by low risk, but the returns have mostly been concentrated in a few large-cap stocks.
Bottom Line:
The market continues to be in a low risk environment.  An isolated “spike” in volatility can be expected during very low volatility.  Unexpected events do not create an immediate shift from one extreme to another (bullish environment to a bearish environment). A major shift in the market environment (Market State) is a process that requires time.
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.

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