Risk Declining as Market Turns Bullish

Risk Declining as Market Turns Bullish

Posted on May 07, 2018
Market State 4: Bullish (6 days): The S&P 500 recently moved back to a bullish Market State environment (Market State 4) This bullish shift occurred following 58 trading days in high risk Transitional Market State environment.
Canterbury Volatility Index (CVI 86): Volatility continues to decrease. The Portfolio thermostat’s volatility indicators will turn out right positive if the volatility can decline to CVI 82.
Shift in Market State and decrease in volatility:
The return to a new bullish Market State does not necessarily mean that the market will go up from here, although higher prices would be the path of least resistance. The change to a bullish environment should equate to less risk than before, as well as a sharp decrease in the number of one day outliers of 1.5% or greater (up or down). For example, of the 58 days, in the transitional market environment, 29 days were up or down more than 1% (50% of the days). The last 6 days, in a bullish Market State, has had only 1 day (up more than 1%).
2018 has seen more than its share of volatility. That said, the S&P 500 remains flat for the year +0.2% (a lot of smoke but not much fire). The NASDAQ 100 is up 4.8%, a meaningful advance, plus future market performance studies have shown that future returns tend to be higher when the NASDAQ is outperforming the S&P 500. The strongest Sector, year to date has been Information Technology (up +7.5%). The worst Sector is Consumer Staples (-12.4%).  Again, markets are expected to perform better when Technology is out-performing more defensive sectors like Consumer Staples.
The stocks only Advance /Decline line, the number of stocks going up as opposed to down, continues to show the broad breadth of participation in the market. As can be seen in the chart below, the A/D line is close to a new high while the S&P 500 is not close to a new high. The fact that the A/D line is stronger than the S&P 500 is called a “positive divergence” and is a bullish development.

S&P 500 (top) and Advance Decline Line (bottom) ; Source: AIQ
The S&P 500 is down -7.3% from its highest peak at 2873 on January 26th of this year. The definition of a “bull market correction” is a 10% decline from the peak. In other words, a 10% correction is considered normal market noise. Market noise, during a bull Market State, is random and unpredictable.
The Canterbury Portfolio Thermostat
The Canterbury Portfolio Thermostat is an “adaptive portfolio strategy.” The primary objective of our adaptive strategy is to hold securities that will create and maintain an efficient portfolio through variable market environments. The Portfolio Thermostat methodology strives to keep the internal “Portfolio State” in a bullish environment regardless of the overall market environment. In other words, the Portfolio Thermostat monitors the holdings daily to confirm that they are maintaining the defined “internal” metrics that are consistent with producing a low risk portfolio.
As of today, the Portfolio Thermostat fund is in Portfolio State 2 (low risk/bullish). The portfolio’s volatility is at CVI 60, within the optimal volatility range. An efficient portfolio should not have a peak to trough correction that would exceed -8% to -10% with rare outliers in the -12% range. The Portfolio Thermostat continues to adapt to maintain “bullish” characteristics in all environments.  Traditional portfolio management, on the other hand, only offers a fixed allocation is incapable of combating the risks of a highly volatile bear market.  
Bottom Line:
The S&P 500 has now shifted into a Bullish Market State with declining volatility.  Bull Markets are a primary indication of risk and it is less likely to see “outlier” days while in a bullish Market State. As of today, the Market is showing many positive signs.  Markets go through many phases and it is important to have a comprehensive system that can adapt to new market environments.  A traditional, strategic portfolio lacks the capabilities to adjust to new environments and could subject a portfolio to increased risk (a drawdown beyond a bull market correction).
The Portfolio Thermostat’s aim is to reverse the traditional risk/return relationship. By holding the properly diversified portfolio (the combination of securities that match the existing market environment), the Portfolio Thermostat should hold declines to the normal bull market correction of about 10%.  A portfolio of securities that create the efficient portfolio should also have the ability to participate in bull market rallies.
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.