Bull Market States, Bear Market States and Trading Anomalies

Bull Market States, Bear Market States and Trading Anomalies

Posted on May 13, 2019

Market State 2: Bullish

Canterbury Volatility Index (CVI 59) The low in volatility was CVI 58 on 5/6/19. Low volatile periods are subject to single day outliers called “trading anomalies.”

Bull markets are typically accompanied by low or decreasing volatility. There is no such thing as a volatile bull market. Overall, investors’ moods are generally cautious. Thus the saying, “Bull markets will crawl a wall of worry.” Bull Market States trade in a rational manor.  Thus, a diversified portfolio, with low correlation among the securities held, will experience a significant reduction in risk. Risk, during a bull Market State environment, is typically limited to a “correction” defined as an 8% to 12% decline from the peak value. These market “pullbacks” (-5% or less) and “corrections” occur randomly and are difficult or impossible to predict.

Trading anomalies, defined as a short period of a few large down trading days called outliers. They generally occur during bull Market States and follow a period of extremely low volatility. Trading anomalies tend to generate a lot of short-term emotion, and extensive media coverage because they come as an unexpected surprise.

Trading anomalies are often confused with the beginning of a bear market. Both display similar irrational behavior. The difference between the two, is that a “trading anomaly” seems to occur out of nowhere, typically at or close to a new high.

On the other hand, an irrational bear-Market State is typically preceded by an extended period of high or increasing volatility and decreasing prices. Investors become emotional as they see months of large swings, more down than up, in the value of their portfolios. They tend to trade based on their gut feelings. Unfortunately, markets generally behave in a counter intuitive manor, particularly during bear market environments. Investors tend to feel the most pessimistic at, or near, the market bottom. Once the sellers are washed out, then a transition period will begin and eventually a new bull market follows.

It is important to note that Canterbury studies show that low volatile bull Market States, followed by a few trading anomalies, will not shift to a bear market, over a short period of time. It takes an extended period of increasing volatility to shift investor psychology to move from a buy/hold/rebalance mentality, that is popular following an extended bull market, to the other extreme. Which is panic selling, which tends to happen near a market bottom and prior to a substantial rally.

Traditional portfolio management discourages selling or adapting the portfolio to match the existing market environment – bull or bear. Conventional wisdom says to just hold your positions in order to confirm that investors will not miss the “big up days when they occur.” They say that missing the largest up days will have a significant impact on total returns over the long run.

What these pundits do not understand is that both, the largest up days, and largest down days typically occur during bearish Market State environments. The exception is the daily outliers during bull Market States.  In other words, it is best to adapt and stabilize the portfolio, during bear markets, to reduce the impact of these multiple large daily outliers that occur over an extended period. The problem is that traditional portfolio management can not distinguish the difference between a bull and a bear market environment. As a result, traditional buy and hold for the long-term (called strategic asset allocation) has no answer for a bear market.

Bottom Line:
Today (Monday) is a prime example of a Trading Anomaly. The day’s activity will be analyzed and scrutinized every way possible by the financial media. Today is just an outlier… a “trading anomaly.”  This is not the beginning of a bear market. It will soon be forgotten.
 
 
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.