Transitional Market Environments Are Volatile

Transitional Market Environments Are Volatile

Posted on October 28, 2014

Canterbury Portfolio Thermostat-Weekly Update- 10/27/2014

Market State 2 (76 Trading Days) Long-term (Bullish) Short-term (Transitional): A transitional environment is one that has experienced a larger than normal increase in volatility. Transitional markets are very noisy. They tend to eventually transition into a Bear market or will go into a consolidation/trading range period and return to the previous Bull market environment. The second is the most likely.

Canterbury Volatility Index is at CVI 71 (Bullish): The CVI volatility increased another 4 points from the previous Friday. The low volatility reading was on September 22nd at CVI 40.We have seen a 78% increase in volatility from the low, which is a substantial increase. 

The Portfolio Thermostat’s volatility indicator has not turned negative. The Velocity of Volatility indicator did not trigger a volatility alert and the CVI remains below CVI 75. 

Canterbury performed a study to determine the typical maximum market correction when the Portfolio Thermostat is in one of the five Bullish Market State environments and the volatility is at CVI 75 or lower. The study was performed using daily, end of day, data on the Dow Jones Industrial Average. The study covered the period from June 1929 through August 2014 (over 21,000 trading days). A “Bull Market Segment” was defined as the total number of consecutive days that qualified (CVI 75 or less and Bull Market States 1 through 5). Some Bull - Segments lasted for over 4 years, while others lasted only a few days.

The results of the “Bull – Segment” test exceeded our expectations. Here are the results:

Long Term BULL Market environment - Market States 1 through 5  

                           

Volatility: CVI=75 or Lower

Largest 5 market peak to trough corrections (largest decline within the segment)  

           

“78” (133 days) Ave CVI 65 -12.70%

“78” to “79” (239 days) Ave CVI 52 -11.70%

“54” to “56” (712 days) Ave CVI 53 -10.03%

“72” to “73” (294 days) Ave CVI 49  -9.87%

“92” to “94” (660 days) Ave CVI 55   -9.48%

Please note that each of the 5 “complete “Bull Market Segments” had positive returns over the periods covered. The “red” percentage number just reflects the maximum decline experienced within the Bull Market Segment. 

Observation: 

The Portfolio Thermostat model study was able to provide statistically relevant probabilities that the model could correctly identify the difference between a high risk Bear market environment versus a low risk Bull market environment. Bull market environments are typically limited to normal corrections in the 10% range.

Overbought/Oversold "Oscillator” is currently 99% overbought (Short term: Bearish). The indicator reached an extreme 99% overbought level last Friday. The 99% overbought reading is not a surprise because the equity markets had a very strong week. S&P 500 index rebounded 3.6% for last week, the Dow Jones Industrial Average was up 2.1% and the NASDAQ Composite jumped 4.8%. 

Market Comment:

The Portfolio Thermostat has remained in Bullish Market States (a Bullish environment) since the end of 2011. If I were marooned on a deserted island, with nothing but my computer and the Portfolio Thermostat program, I would be convinced that the folks back home were experiencing utopia! I would have never guessed the markets were capable of shrugging off so many major or tragic events. These events barely registered a blip in the S&P 500’s pricing. Well, at least that was true up until two or three weeks ago.

The markets have withstood events like the fiscal cliff, the sequester, Russia's invasion of Crimea, the Russian troop buildup in eastern Ukraine, ISIS, the attack on the US embassy in Bosnia, protests in Hong Kong and several other tragedies. So the question is, what major event world event triggered the current market correction and caused the largest increase in volatility seen in years? Could the increase in volatility be the result of two health care workers who were infected with Ebola? I don’t think so.

 

Fortunately markets are not driven by news events or whatever the talking head experts “think” will happen. These short term events may cause a little noise in the markets but they are not the primary drivers of market prices. Market prices are driven by the Law of Supply and Demand. Supply and demand is driven by what buyers and sellers want and don’t want; by what they believe to be true or false and how rationally or irrationally they think their current beliefs are accurate. The Law of supply and demand determines the price and the degree of the volatility in prices of ALL freely traded liquid assets.

 

The primary cause for the recent market fireworks is simple, volatility has gotten too low and remained too low for too long. Extremely low volatility is a sign of investor complacency. I have used the analogy of squeezing down a spring. The longer and tighter you squeeze the spring the bigger the pop when you let go. The market’s low volatility and tight trading range increased the probabilities of a sharp increase in short term volatility. This is exactly what has been occurring over the last three weeks.  

There is no question that the overall equity market environment is in transition. Volatility, as measured by the CVI, has increased at a higher and faster rate than at any other time in over two years. The S&P 500 declined -7.4% in just 19 trading days. When it appeared that the market was going down for the count, then came the typical highly volatile rally. High volatility is a sign of a less efficient or an inefficient market. Sharp rallies are not necessarily a positive sign.

Markets do not immediately shift from a complacent Bull market environment to a Bear market environment overnight. Investors go through a “transitional” period following the initial market shock. A sudden pop in volatility will either begin to stabilize and will eventually resume the previous stable Bull market environment or the swings will get larger and will result in the beginning of a new Bear market.

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.

Bottom Line:

It is not typical for the market to experience a volatile correction and then go right back to hitting new highs like nothing had happened. The V pattern (sharp decline and sharp advance) is very unlikely. The higher probability is a pattern that would resemble a W. 

The most likely short term direction following the short term rally will be another decline and maybe a retest of the old lows. The good news is our longer term indicators are improving. My friend David Vomund, at Vomund Investment Management has a proprietary stocks-only Advance Decline Line. He said that the AD line is up for October while the S&P 500 is down. The market breadth is improving.  The current correction remains in the normal and expected range. Probabilities favor an eventual resumption of the Bull market environment we have grown accustomed to over the last three years.

Canterbury Investment Management: Tom Hardin

More About Tom Hardin

As Chief Investment Officer, Tom Hardin, Chartered Market Technician (CMT), makes all the final decisions on all investment and portfolio management decisions for Canterbury Investment Management. Tom has more than 30 years experience in the investment management industry and has broad breadth of knowledge. He is known as an innovator, educator and been revolutionary in the advancements in 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.