Patience is a Virtue

Patience is a Virtue

Posted on June 15, 2015

Canterbury Portfolio Thermostat™

Weekly Update

6/15/2015

Market State 2: Long-term - Bullish; Short-term - Bullish/Neutral. The current Market State 2 has been in place for the last 11 trading days. The S&P 500 has spent the entire year in either Market States 1 or 2. MS 1 has totaled 41 trading days and MS 2 has covered 71 trading days so far in 2015.

Year to date, the S&P 500 has been in a tight sideways trading range. The high for this year was 2130.83 and the low was 1992.67. The total trading range, between the high and low, has been 6.8% and a total gain, year to date, is 2.68%.

The 20 year Treasury bond ETF (TLT) is currently in Bearish Market State 12 and is down -5.36% so far in 2015.

Canterbury Volatility Index (CVI): CVI 51 - The volatility (as measured by the CVI) got as low as CVI 49 last week (CVI 49 is the record low for 2015). The current volatility would be defined as an “extremely low” level.

Quote from Last Week’s Update:

Stuck in The Mud. “Keep in mind that the one-day outlier (a move either up or down in the 2% range) is likely when volatility is at an extreme low level.” These one-day outliers seem to occur during static markets when most would least expect them.

The One-Day Outlier:

Last Wednesday was an outlier, up 236 points and reached as high as up 280 points. As expected, from a “one-day outlier” the following day traded pretty much flat and Friday was a down day.[1]

The Overbought/Oversold indicator is now at 30% overbought compared to 19% the previous week. The increase is a very slight negative for the short-term market. A reading of 5% to 10% Overbought (or 90% to 95% Oversold) would be considered to be an extreme level and would be short-term Bullish.

Special Report

Canterbury Portfolio Thermostat Market State Study
(7/23/1929 through 5/29/2015 - 21,563 trading days)

Changes in Market Environments are reflected in the Portfolio Thermostat’s “Market States”

Markets rotate through many different environments, ranging from rational to irrational and optimistic to pessimistic. Identifying the primary market environment is comparable to separating the black from the white, but many shades of grey lie within each category. Hence, each of the two primary market environments are subdivided into multiple market states with each exhibiting its own unique traits and tendencies. The Portfolio Thermostat then optimizes a custom asset allocation and targets Exchange Traded Funds (ETFs) that best fit the unique characteristics of the current market environment.

The following study examines the characteristics of the Portfolio Thermostat’s 5 Bullish Market States, compared to the other 7 (3 Transitional and 4 Bearish Market States).

  1. We found that 12,837 (59.53%) of the trading days qualified as being in Bull Market States. The remaining 8,726 days (40.47%) were in Transitional or Bear Market States.
  1. The Bullish periods were broken into 71 periods. Each Bull period ended on the day the Market State shifted to one of the 7 non-Bullish States.
  1. Of the total 12,837 “Bullish-Market State” days, 8,934 (69.60%) were in stagnant trading ranges (extended periods when the market could not exceed its previous high). This means that almost all of the profits (except for dividends) were made in just 3,803 trading days (30.40% of the total days) spent in Bullish Market States.
  1. The largest decline (drawdown) when in one of the 71 Bull Market State periods was -12.70% and the volatility was at CVI 100 or lower (5/1/78 through 10/31/78). This falls in the range of a normal Bull market correction.

[1]

As a point of reference, a CVI of 75, or lower, is considered to be a “safe zone.” Canterbury has performed numerous studies on the impact of volatility on markets and securities. Our studies have provided evidence showing that low and decreasing volatility is a primary characteristic of a Bullish market environment.


Figure 1: The Market States matrix give an overview of the different characteristics and components that are typical of each of the 12 Market States.

Observation - Should We Just Buy and Hold and be Patient?

Investor patience is more than a virtue when in Bullish Market States or when holding securities in Bullish Security States. As discussed last week, Bull markets spend a high percentage of the time in a trading range going nowhere. The meaningful advances tend to occur during short periods of time when most would least expect them.

Investors’ patience is NOT rewarded when they “buy and hold” securities that are in Bearish - Market States. The volatility and losses incurred during Bear markets will ruin a portfolio’s efficiency and destroy the possibility of achieving long-term compounded returns.

The price of a security is driven by supply and demand. All liquid traded securities will eventually experience Bear market periods (substantial declines in price). In fact, a security can experience a substantial loss even though the underlying company may have reported earned profits.

There are major differences between the direct ownership of a privately held company versus the ownership of a publically traded stock.

Private ownership vs. Public ownership

  • The ownership of a private company is typically not liquid. Therefore, the owner’s success or failure will depend on the company’s ability to produce profits consistently
  • The private owners of a company will be required to absorb all losses even though the future outlook for making money is good.
  • The ownership of a publically traded stock is liquid. Therefore, the price of the stock will fluctuate based on the supply and demand for the shares in the market place.
  • The publically traded shares of a company in a Bullish- Security State can appreciate in value even if the underlying company is not profitable.
    • Ex. Tesla lost $2.90 a share in 2014 but the stock appreciated 47.85%. The opposite can also be true. One of Warren Buffett’s “favorite companies” IBM made a $5.50 per share profit for 2014 but the publically traded stock spent a good part of the year in a Bearish-Market State and declined -14.46%.

Patience is most likely not a virtue for a private owner of a company that consistently loses money. Having patience is not a virtue for those who “Buy and Hold” through Bearish Market States.

The price of a security is driven by supply and demand. All traded securities will eventually experience bear market periods (substantial declines in price) regardless of the profitability of the underlying company. Buying and holding declining securities that are in Bearish Market States, will ruin a portfolio’s efficiency and destroy the possibility of achieving long-term compounded returns.

Securities, like Exchange Traded Funds (ETFs), are liquid for a reason. Investors will be penalized, not rewarded, for holding ETFs through Bearish market environments. On the other hand, investors are rewarded for having a successful process to adjust holdings to match the existing market environment. Investors will also be rewarded for having the patience to stay invested through Bullish Market States, even though bull markets experience periods of sideways trading and normal corrections, typically in the 5% to 10% ranges.

Bottom Line:

Markets and securities are difficult to manage and so is managing a profitable company. Both require evidence-based processes and applications built on objective rules and tested methods.

Hold ETFs that are in Bull Market States. Sell any ETF the day it shifts to a Bearish Market State. Liquidity is only a benefit if it is used properly.

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.