The Primary Benefit of Financial Markets is Liquidity

The Primary Benefit of Financial Markets is Liquidity

Posted on January 08, 2018
1/8/2018

Market State 1: Bullish/Rational (88 trading days): The Portfolio Thermostat operating system identifies the characteristics of 12 different market environments called “Market States.” Market States 1 and 2 have the lowest risk, of the 12 environments. Market States 1 and 2 have registered the most new market highs. The current run of 88 days, in Market State 1, has been very efficient and orderly while recording 36 new highs.
• 5 Bullish (rational) Market States
• 4 Bearish (irrational) Market States
• 3 Transitional Market States(indicating caution, which tend to precede a change from Bullish to Bearish.)

Canterbury Volatility Index (CVI 34): Normal/efficient market volatility will typically run in the CVI 46 to CVI 75 range. Extremely low volatility, according the Canterbury Volatility Index, is at CVI 45 or lower.

We are in a Low Risk/Bullish market environment. A 5% correction, from the most recent peak, would be normal bull market pullback, and would fall within the definition of “normal market noise.” Normal market noise is random and therefore unpredictable.

Canterbury’s Study of Extremely Low Volatility
It is rare to experience extremely low volatility in the equity markets. A Canterbury Analytics study looked at the daily data on the Dow going back to December 31, 1896. During that time, only 14.5% of the trading days qualified as extremely low volatility (CVI 45 or lower). Rarer still, are long periods of extremely low volatility; i.e., 200 consecutive days or longer.

The Dow Jones Industrial Average’s current streak of volatility below CVI 45 and price above the 200-day moving average has now reached 262 trading days, which surpasses the second longest streak of 254 trading days from March 1944 through March 1945.

The following are some statistics on the 10 longest streaks with volatility below CVI 45 and price above the 200-day moving average:

Chart 1: The maximum declines and run-up during long periods of extremely low volatility


Observation:
Long periods of extreme low volatility have the following characteristics:
• Very slow upward assent in an orderly/efficient fashion.
• There is no parabolic advance which is typical of a bubble.
• Market declines (pullbacks) rarely exceed -5% from the peak.
• About 25% of all New Highs have occurred when CVI is 45 or lower.
• Investors, as a group, tend to be nervous thinking that the market is too high and expecting a sharp decline… which does not happen.
• Unexpected major world events only have a small impact on market pricing during periods of low volatility. (The second longest run of extreme low volatility began several months before D-Day World War II.)
• The current streak of low volatility is the second longest. The maximum decline (drawdown) was -3.37% and the maximum (trough to peak) run-up has been +28.19%.

Comment:
The S&P 500 has put in 74 new all-time highs since the beginning of this streak of extreme low volatility (beginning on 12/22/2016). Another healthy market characteristic is a continual rotation, in leadership among the ten S&P 500 Sectors. The market has remained stable while most sectors have had intermittent runs followed by orderly pullbacks to digest the gains.

Below is a chart showing the sector rotation from the beginning of the low volatility period (December 22nd, 2016). Each number shows the ranking of sector (out of 10 sectors) for the period. This ranking is based Canterbury’s Volatility-Weighted Relative Strength (VWRS).

Chart 2


Observation:
With the exception of Technology and Industrials, each sector has taken its turn at or near the bottom rank. Each sector, with the exception of Real Estate and Consumer Staples, has held one of the top 3 positions. A rotation in leadership among sectors is healthy by showing that each sector has experienced a period of higher risk-adjusted return rather than a single sector carrying the herd.

Is the market overbought? Should we sell or buy more?
All markets and traded securities have low risk bullish periods and high risk bearish periods. Markets are liquid for a reason, they assume that the investor or portfolio manager can tell the difference between a high risk and low risk environment.

It is the portfolio managers’ job to manage the primary benefit of owning securities: their liquidity. Liquidity makes it possible to adjust our holdings for the purpose of making adjustments to maintain an efficient portfolio through variable markets. An adaptive portfolio management strategy requires a process to manage and coordinate all aspects of asset allocation, diversification, security selection and portfolio optimization.

Similarly, the President of a company must manage all aspects of his or her operation as an interconnected and coordinated unit. Management must have a process to continually adapt to the changing business climate.

Those corporate managers who lack a process to effectively manage a company’s day to day operations will most likely suffer the same fate as a portfolio manager who has no process to manage the liquidity within the portfolio. Neither is likely to achieve a reasonable risk/return relationship over the long run.

Chart 3 shows the poor risk/reward relationship of a long term buy and hold strategy.

Source: AIQ

Bottom Line:

Understand that a shift from a low volatile environment to a volatile/risky environment will require a substantial change in investor behavior. Such a shift in beliefs does not occur over night. The current low risk environment should remain intact for the near future.

The Canterbury Portfolio Thermostat operating system monitors for leading indications of a change in the market environment on a continual basis.

 

 

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.