Volatility is Relative

Volatility is Relative

Posted on February 02, 2015

Canterbury Portfolio Thermostat Weekly Update 2/02/2015

Market State 2 (27 days) Long Term (Bullish) Short Term (Neutral): The Portfolio Thermostat is composed of 12 different Market States. Each Market State represents a different market environment. Of the 12 Market States, 5 are Bullish, 4 are Bearish and 3 are Transitional.

 

The Portfolio Thermostat model is off to a good start for 2015. The model had a strong 4th quarter and was able to hold on to most of its gains through a difficult January.

The Canterbury Volatility Index (CVI) closed at CVI 74 (Bullish/Low Risk). Volatility, as measured by our CVI, increased by 3 points from the previous Friday’s close. A 3 point increase is not significant, in itself, but a break above CVI 75 would exceed the Portfolio Thermostat’s maximum requirement to qualify as the lowest risk market environment.

 

If the CVI increases another 2 points (increase from CVI 74 to CVI 76) then the S&P 500 index would then shift to Transitional - Market State 6. A move to Market State 6 will not force a change in the model’s allocations. That said it would require that the first two Global Equity Group ETFs that are sold to move the funds received to the “Alternative” to Global Equities Group of ETFs.

 

Comment on CVI Volatility:

Volatility and market risk are universally deemed to be the same thing. Increasing volatility indicates a lack of stability or an imbalance between the levels of supply versus demand. In other words, applied scientific studies, based on defined rules, have provided evidence that increasing volatility means increasing risk and can provide an early indication of a change in market environment, typically a bearish change.

 

The major U. S. equity indexes have recently experienced an increase in volatility. That said the market’s volatility has felt worse than what it has actually been. For example, there have been several wild “intraday” price swings that ended with little price change.

 

Most “intraday” fluctuations are caused by investors’ knee jerk reactions to random “intraday” news events.  In other words, hour to hour fluctuations are more about market “noise” than they are about providing an indication of a true increase in volatility that could lead to a change in the market environment. Either way, market noise is just a part of the cost of maintaining liquidity in securities and has no meaningful impact on the macro market environment.

 

The Canterbury Volatility Index (CVI) is calculated by using the end of day closing value. Therefore the “intraday” market fluctuations are ignored. Normal bull market “systemic” market risk (meaning risk/fluctuations that can’t be diversified away) is typically in the 5% to 10% ranges. A bull market “pullback” is defined as a 5% decline from the previous peak value. A bull market “correction” is defined as a 10% decline. Such fluctuations are considered to be normal market noise within a long term bull market.

 

Market Comment:

The CVI, as a measure of volatility, registered a 4th quarter low at CVI 52 on 12/9/14. From that time through last Friday, the market’s CVI has increased by 42% while the S&P 500 has only declined 3.1%. The market actually had a small gain, until 6 trading days ago, in the face of increasing volatility. Since increasing volatility is a “leading indicator,” it is normal to see an increase in volatility followed by new highs in price.

 

Short term outlook is neutral:

  • US equity markets have been locked in a trading range.
  • Our overbought/oversold indicator is 82% bullish/neutral. It would be outright bullish if it could get to 95% plus bullish. This would probably require more of a market sell-off or a sideways period.
  • The stocks only advance/decline line is neutral.
  Bottom Line:

When taking into account the fact that the S&P 500 and Dow have already pulled back 4.6% and 4.9% respectively from their 12/26/14 highs, the short term market risk should be limited to less than -5%.

 

There is no reason to believe that the current market environment will be turn bearish or be much different from the previous five “whipsaws” experienced last year (whipsaw: short term sharp declined followed by a rebound, typically back to a new high).

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.