Don't Confuse Market Volatility with Investor

Don't Confuse Market Volatility with Investor "Headline Fear"

Posted on August 04, 2014

Canterbury Portfolio Thermostat - Weekly Update – 08/04/14

Market State 2 (16 trading days) - Long-term: Bullish; Short-term: Neutral.

The Thermostat’s Overbought/Oversold indicator is now at 95% oversold (Bullish). Last week’s sell-off finally pushed this indicator to the extreme 95% plus level needed to make this important component of the Thermostat’s algorithm positive. The next step in resuming the upward trend is to begin gathering some positive momentum.

Canterbury Volatility Index closed Friday at CVI = 48: Last week, the CVI (volatility) increased 6 points reflecting a 14.28% increase in volatility. During the same time, the popular VIX Volatility Index increased by 34.2%. Most of the VIX’s increase occurred last Thursday (27.16%) when the S&P 500 dropped -2.0%.

It is important to not confuse the VIX - "Volatility Index” with the "Canterbury Volatility Index” (CVI). The VIX is named the "Volatility Index” but is more correctly referred to as the "Fear Index." The VIX is calculated based on the S&P 500’s short-term options. The VIX can experience a large increase, over a very short time. This is true because option premiums (time value) can expand rapidly when a knee jerk reaction changes investors’ feelings regarding fear or greed. The Portfolio Thermostat’s CVI is based on the actual short term fluctuations in the S&P 500’s value. This rate of change in value will reflect actual market "volatility.” 

Shifts between supply and demand will impact market direction and volatility. The level of volatility is an indication of current market efficiency. An efficient market will have low or declining volatility and is a characteristic of a Bull market environment. Increasing volatility can be an early indication of a change in market environment, typically a Bearish change. High volatility reflects an inefficient and high risk environment, typical of a Bear market or a Bubble.

Supply and Demand:
There is an old saying "Bull markets crawl - a wall - of worry.” A large increase in the VIX can indicate excessive investor fear (worry) which is typically Bullish for future market prices. On the other hand, high or increasing market volatility is a primary characteristic of a Bubble or a Bear market.

Fearful investors are more comfortable with high levels of cash. These high levels of cash will eventually be invested which will increase demand pushing prices higher. On the other hand, optimistic investors are mostly fully invested and only have a small amounts of cash available for future buying.

Markets move based on the law of supply and demand. Supply and demand are driven by investors’ expectations and beliefs regarding the future. When too many investors are Bullish, the lack of cash available for new buying (demand) means that prices will eventually stall. Their optimistic expectations will eventually not be met. These former Bulls will then become future sellers (supply) and their activities will push prices lower.

The important point to grasp here is that markets are counter intuitive. Your gut feeling, regarding market direction, will most likely be wrong.

Market Comment:
The S&P 500 dropped -2.7% for the worst weekly loss since 2012. Most of last week’s downturn was a result of Thursday’s S&P 500 -2.0% drop. A week ago, volatility reached its lowest level in over 6 years. When a market becomes too complacent and the Canterbury Volatility Index (CVI) reaches an extremely low level, then the probabilities of an isolated one day 200 to 300 point decline in the Dow becomes likely and can occur when least expected. I have discussed, ad nauseum, in previous Weekly Updates, the current high likelihood of having a "one day 2% outlier.” An extended period of extremely low volatility is similar to squeezing a spring between your thumb and forefinger. The tighter it is squeezed, the bigger the pop when it is let go. This is exactly what occurred last Thursday. Since Thursday, the US equity markets have been stable and have traded like nothing happened. This is typical of the Bull market "one day outlier.”

The S&P 500 is up +4.1% so far in 2014 but that is overstating the strength of stocks. Year to date through last Friday, the Dow Jones Industrial Average is down -0.50% and the Russell 2000 is down -4.2%. The month of July finished down for most indexes. The S&P 500 closed down -1.38%, the Dow was down -1.44% and the Russell 2000 lost a whopping -6.05% for the month of July. 

The Portfolio Thermostat’s previous Weekly Update (7/28/2014) discussed several concerns regarding the short term state of the U. S. equity markets:
"The stocks - only” Advance/Decline line (number of stocks going up versus down) did not confirm the new S&P 500 high last Thursday. This causes a "negative divergence” between the index and the breadth of advancing stocks. The previous highs, for both the S&P 500 and the Advance/Decline line, were on July 3rd. Since that time, the S&P 500 has touched its old high but has been unsuccessful at making a decisive breakthrough while, at the same time, the A/D line is close to its July low. The probabilities would favor a sideways to lower short term market environment.”

My friend and market technician David Vomund with Vomund Investment Management discussed some recent history, in his VIS Alert newsletter, regarding the past negative divergences between the S&P 500 and the A/D line: 
"The Advance/Decline Line had a negative divergence for five months before the 2008 bear market and it diverged for at least a year before the 2000-02 bear market. Since the current negative divergence was just one-month, a 5% correction seems appropriate. So far the S&P 500 is down 3.1% from its high. The good news is the indicator is no longer diverging since both the Advance Decline Line and the S&P 500 moved lower. In order for the negative divergence to continue, the S&P 500 would have to reach a new high while the indicator is off its high (below its high). In the meantime, some sideways movement would be constructive.” 
David Vomund: VIS Alert Market Letter

Bottom Line:
Bull markets do not turn into Bear markets overnight. A major shift in the market environment is a process that typically takes several months. As of today, the equity markets remain healthy. The peak to trough fluctuations are typically about 4% to 8% during Bull Market States and 8% to 12% while in Bear and Transitional Market States. The traditional definition of a Bull market correction is a 10% decline from the peak. We are currently experiencing a low level of normal market fluctuation along with a high level of investor fear. Both would reflect a positive market environment. In the meantime, our portfolio continues to adjust its Exchange Traded Funds (ETFs) holdings to match the current market environment.