Friday's Decline Was Expected and May Be Healthy

Friday's Decline Was Expected and May Be Healthy

Posted on September 12, 2016
9/12/2016
 
Market State 6: (1 day). Market State 6 is a Transitional market environment. Most market indexes should be transitioning from an extremely complacent, or low volatile environment to a more normal level of volatility that would be more characteristic of a bull market. Friday’s decline would count as a rare “one day outlier” as the Dow declined 394 points (2.1%) to 18,085, the S&P 500 dropped 53 points (2.4%) and the NASDAQ was hit for 134 points (2.5%).
 
Transitional - Market State 6 will remain in place until the market can return to a stable environment showing that last Friday’s decline was just a counter to the extended period of extreme low volatility.
 
Canterbury Volatility Index (CVI 57): Volatility increased 10 points Friday from CVI 47 the day before. Volatility below CVI 75 is considered to be in the “safe zone” (meaning that short term decline should not exceed a normal bull market correction of about -10% from the previous peak in value). 
 
One exception to the “safe zone rule” at CVI 75 or lower, occurs when our Velocity of Volatility indicator is triggered. Friday’s spike in volatility was more than enough to cause our volatility algorithm to turn negative. I will discuss the most likely scenarios in the following Market Comment.
 
Observation:
Friday’s sharp decline did not come as a surprise to the Portfolio Thermostats algorithms. In fact, a Volatility Alert was highlighted in the last two Canterbury Weekly Updates. Here are some excerpts from last week’s (9/2/2016) update:
 
Low Volatility Alert:
Volatility has now declined below the optimum range of CVI 55 (now CVI 49). Extremely low volatility is similar to squeezing down a spring. The longer and tighter it gets squeezed, the bigger the pop. In addition, our system uses a shortened version of the CVI.  The shortened CVI is used specifically for identifying periods that are most likely to experience potential single day outliers that could exceed 1.5% plus, either up or down. The Short Term CVI is below its optimum range of CVI 35 (now CVI 29).Even though some short term market turbulence is expected soon, our current bullish market stance remains intact.

Source: AIQ Chart 1

 
9/2/2016
Observation
The last time volatility was as low as it is now was in September 2014. Standard CVI 42 and Short Term CVI 22. The low volatility was followed by a 7.4% correction a couple weeks later.

Source: AIQ Chart 2

Market Comment-present (9/12/2016):
Did the shift from “Bullish” - Market State 2 to Transitional – “Market State 6” mean that a significant correction is coming soon? Absolutely not. A market move, like Friday’s, was expected.
 
The Portfolio Thermostat’ indicators issued a “Volatility Alert” that had extended for over two weeks. The alert called for a one day outlier “that could exceed 1.5% plus.” In other words, the spring (volatility) was squeezed down very tight. Most outliers are followed by normal market fluctuations, in other words, the markets would return to stability and behave as if nothing had happened. In a few cases, an outlier is followed by a few days of higher volatility prior to a return to a normal market environment.
 
Bottom Line:
The market is currently oversold. The stocks only advance/decline line (number of stocks going up verses down) hit a new high last Wednesday (meaning that most stocks were participating in the advance). It may just take a few days for the markets to shake off the effects of last Friday.
 
Side Note:
The current bull market has not been as strong as many would think. There has been a great deal conversation regarding the recent highs registered in several major market indexes. One would think that their portfolios should be up substantially. The truth is that most markets have been experiencing difficulty, in moving higher, for some time now. The following are a few examples of the risk/reward trade-off experienced by most investors.
 
                                S&P 500                      S&P 500 Equal Weight      Russell 2000 (small Cap)
Period (ending 9/9/16):  Start 5/19/15: 2127.8    Start 2/15/15: 3324.0   Start 12/29/14: 1219.1
Total Months:                16 Months:     2127.8    19 Months:     3325.5       21 Months:      1219.2
 
Percent Change:                    0.0%                              0.0%                              0.0%
Maximum Gain:                  +3.1%                            +3.5%                            +6.3%
Maximum Loss:                  -15.2%                           -19.3%                           -27.2%

Source: Cornerstone Macro-Carter Worth


In addition to the above extended periods with no return, the risk taken has far outpaced the potential gains.
 
The takeaway, from above, is to understand that financial markets will extended periods of treading water. Most large gains, and losses, occur when the majority of investors would least expect it. This is what is known as the counter intuitive nature of supply and demand. A successful investment program requires the ability to compound returns over the long run. In turn, long term compounding requires a process to avoid substantial declines associated with Bear Market State environments.
 
Therefore, similar to a home thermostat, the Portfolio Thermostat model maintains stability by adjusting its ETF holdings in order to move in concert with the ever-changing markets. The objective is to maintain an “efficient portfolio” regardless of the market environment – bull or bear. 
 
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.