Risk Management is Still Important During This Bull Market

Risk Management is Still Important During This Bull Market

Posted on November 14, 2017
Market State 1 Bullish/Rational (52 trading days): The S&P 500 has been in one of the 5 confirmed “bullish” Market States since July 8th of last year.
Canterbury’s studies have provided statistically relevant evidence showing that risk is limited when the market is in a bullish Market State. Meaning that a normal “pullback” (defined as a -5% decline from the highest previous peak in value) can occur at any time. Such pullbacks are considered to be normal market noise, and represent a normal consolidation of a previous advance.  The typical maximum decline, in a bullish Market State, should be limited to a market “correction” of about -8% to -10% with rare outliers in the -12% range measured from the previous highest peak.
A typical bullish market environment is marked by low volatility and a stair step chart pattern of higher highs and higher lows. We remain in a low risk and slow-moving bull market.

Source: AIQ

Canterbury Volatility Index (CVI 28):  I understand that CVI 28 is just a number. It is difficult to put into perspective the unique nature of the current extremely low market volatility. Canterbury’s portfolio analytics group has performed many studies on the impact of changing volatility on the markets and portfolio’s.
Canterbury maintains a daily record of the market’s daily volatility, as measured by the CVI, going back to 12/31/1896 (more than 32,800 trading days). The lowest volatility reading ever recorded was CVI 26. In addition, there have only been 34 days when the volatility was at CVI 28 or lower.

So, what can we expect in the current low volatile market environment?
  1. Low volatility is a primary bullish characteristic.
  2. Low portfolio volatility means that the diversification among holdings is working, in the current market environment.
  3. The current low volatility (CVI 28 or lower) has only occurred on 34 times out of 32,800 trading days. Therefore, there is not enough data available to draw any statistically significant conclusions regarding the future market action.
  4. We have performed statistically valid studies on the impact of extremely low volatility on market returns. During such times, there is a definite tendency to experience one day outliers of 1.5% or more (up or down). These “one day outliers” are typically followed by normal trading days, as if nothing had happened. The current environment may be subject to multiple outliers that could serve to relieve the built-up pressure from a lack of movement.
  5. Our studies show that periods of low volatility are typically followed by periods of higher than average volatility. In other words, market volatility can only stay this low for so long and will eventually go higher. That said, markets do not go from one extreme to another over a short time frame. A shift from a low volatile bull market to a high volatility transitional or bear market requires time to change the psychology of the market. In other words, a substantial shift from low to high volatility is a process.

The Canterbury Portfolio Thermostat is an adaptive strategy designed to manage all market environments – low volatility bull or high volatility bear. In order for the portfolio to meet its objectives, the following “internal” benchmarks should be met.

Canterbury Portfolio Thermostat Internal Benchmarks:
Portfolio should maintain a low risk Portfolio State:
Portfolio State: Efficient - Low risk - Bullish  

Source: CIM
Portfolio should maintain low and consistent volatility:
Portfolio Volatility (CVI 24): Low Risk - Bullish
Portfolio should limit declines to normal “corrections” of -8% to -12%:   
Portfolio maximum decline (trailing 12 months): -3.4% - Objective Met
Portfolio should have risk reduced by 30% or more through diversification:
Portfolio’s Benefit of Diversification = 37%* - Objective Met
The current diversification among the portfolio’s holdings meet all of the, internal benchmarks’ requirements to qualify as an “efficient portfolio” based on the today’s market environment: Objective Met
Canterbury’s definition of an “efficient portfolio” is one that can limit risk to normal bull market pullbacks or corrections of -8% to -12% during any market environment. On the other hand, the portfolio should perform similar to an all equity portfolio during periods of low volatility.
Canterbury Portfolio Thermostat – 11/10/2017

Source: AIQ
*Example - Benefit of Diversification (B of D):
Let’s say that the portfolio holds 10 ETFs. Each ETF has volatility of CVI 100. The average volatility would be CVI 100. Let’s say that the portfolio’s risk was reduced as a result of the diversified holdings moving different from each other. In this example, the portfolio has volatility equal to CVI 50. The net percentage Benefit of Diversification (B of D) is 50%.
  • Average of 10 Portfolio hold holdings = CVI 100
  • Volatility of portfolio = CVI 50
  • Benefit of Diversification = 50% [1-(50/100)]
Bottom Line:
Successful portfolio management is all about risk management and portfolio efficiency. If one cannot manage risk, then one will be unable to manage the long-term outcome.
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.