Market Environments and Outlier Days

Market Environments and Outlier Days

Posted on November 25, 2019


Market State 1 (Bullish)- The S&P 500 remains in Market State 1.  Market State 1 is one of the 5 bullish Market State environments.  The market has been in Market State 1 for the last 25 trading days, dating back to October 24th. As a reminder, there are 12 Market State environments- 5 are bullish; 3 are Transitional; 4 are bearish.  The characteristics of each Market Environment (bullish, transitional, and bearish) are shown in the table below:

 
Canterbury Volatility Index (CVI)- CVI 53: The Canterbury Volatility Index reading of CVI 53 indicates that volatility continues to decline.  Volatility has been declining steadily since the start of October.  As we have pointed out in recent weeks, the short-term volatility (a 10-day volatility index) is in extreme low territory, and currently measures a volatility reading of CVI 24.  Remember, that when volatility gets squeezed down, it is similar to the squeezing down of a spring.  Often the market will release pent-up pressure in the form of an outlier day (usually a day beyond 1-1.50% up or down).

Canterbury Portfolio Analytics Group performed a study of short-term volatility and how many periods short-term volatility has fallen below CVI 25.  Dating back to 1950, short-term volatility has dropped below CVI 25 seventy-four (74) different times, before breaking back above extreme low territory at CVI 45.  Of those periods, over half (47 periods) ended on a day greater than +/- 1.00% (33 of them were down more than 1.00%; 14 were up more than 1.00%).

Additionally, Canterbury Analytics Group measured what happened in the market 3-months following an extreme low short-term volatility period.  Of the 74 different periods, 31 of the periods experienced at least a -5.00% drawdown over the next 3 months, with only 9 of those periods experiencing at least a -10.00% drawdown from peak value.  Of those all 74 periods, only 4 of them experienced what is considered beyond a normal bull market correction of -12%.

Markets will not go from a bull to a bear overnight; there is a process to transition from bull to bear.  While we can see spikes in volatility during bull markets, it is highly unlikely the market would go from a low volatility bull, to a high volatility bear instantaneously.

Comment
It seems like awhile ago when we last saw an outlier day beyond +/-1.50%.  In fact, there has not been an outlier day beyond +/-1.50% since the beginning of October.  This is because, as shown in several Canterbury studies, Markets are not random.  Outliers in markets are less likely to happen during bull markets, but much more likely to happen during bear and transitional markets. 

To give a brief example of this, below is a chart showing the daily returns of the S&P 500 from 2006-2009.  For most of 2006/2007, you can see (based on the green background), that the market is in a bullish environment, with a few transitional environments in between.  During the bullish environments, the daily fluctuations of the market generally fall within 2 standard deviations (which would be -2.00% to +2.00).  The market should fall within 2 standard deviations about 95% of the time.  When the market then turns Transitional in 2007, we see there are many more days pushing a third standard deviation of +/-3.00%.  Finally, as we get into the Financial Crisis, the market turns bearish and experiences a high degree of volatility, ranging from -10% days to +10% days. 

source: CIM
Markets are not random.  Bear markets will be much more volatile than bull markets.  More importantly, there is a process to go from a bull to a bear. 

The chart below shows the S&P 500 daily returns since April of this year.  Notice that there are many more days beyond 1.50% when the market is in a Transitional environment versus when the market is in a low volatile bullish environment.  In fact, since turning the Market State 1, we have yet to see an outlier day beyond even +/-1.00%.  We saw multiple days beyond this level back in the late summer.

source: CIM
Portfolio Thermostat
The Canterbury Portfolio Thermostat does not aim to compete against any individual index or blended benchmark.  We know that portfolio efficiency is a moving target, and all asset classes will go in and out of favor.  The Portfolio Thermostat is an Adaptive Portfolio Strategy designed to navigate various markets and create an efficient portfolio for today’s environment- Bull or Bear.
 
Canterbury benchmarks its portfolio against key “internal” metrics, in order to measure portfolio efficiency.  These metrics are Portfolio State, Portfolio Volatility, and Portfolio Benefit of Diversification.  Together, these internal benchmarks create the Portfolio Efficiency Score.




The Portfolio Thermostat remains efficient for the current market environment.  We have mentioned throughout the update that because short-term volatility is low, there is an increased probability of seeing an outlier day in the market.  If this does occur, the Portfolio Thermostat should be properly positioned to deal with a market outlier, given its higher degree of diversification. 

Bottom Line
The market, as measured by the S&P 500, remains bullish with low/decreasing volatility.  Short-term volatility is at an extreme low, which does increase the likelihood of an outlier, but there is no telling when that would occur or to what extent.  We know that low/decreasing volatility is a positive sign for the markets, and the Portfolio Thermostat is efficient and properly positioned to navigate the current environment.  Should that environment change, the Portfolio Thermostat is an adaptive portfolio strategy and will make the necessary adjustments to adapt to a new 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.

 
Canterbury Investment Management: Tom Hardin

More About Brandon Bischof

Brandon is directly responsible for managing the Canterbury Analytics Group (CAG). To date, Canterbury Analytics Group has played an important role in advancing portfolio management from a loose art form based on subjectivity and obsolete assumptions to an adaptive process with scientific rules and methods capable of providing evidence based results and statistically relevant value add results.


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.