March 9th marked the 3 year anniversary of the current bull market. The S&P 500 has scored an impressive 110% run-up, and I think we can officially declare that the dreaded double dip recession didn’t happen.
However for the buy and hold investor there isn’t a lot to celebrate. We are still 16% below the S&P 500′s 2007 peak. Not including dividends a January 1, 2007 investment in SPY, an ETF that tracks the S&P 500 would still be down 0.7%. Adding dividends improves the return to +10%, but that’s only a 1.6% annual growth rate—certainly not enough to keep up with inflation.
After the 56% decline from the S&P 500’s peak in 2007 the market had to climb 131% from the bottom to break even—depressing. Some advisors counsel patience saying that the value of the companies in the S&P 500 didn’t really go down by that much, so it’s not so daunting to get that much growth.
But others argue that the market has fundamentally changed with this go no-where cyclical pattern that started in 2000. The ferocity of the 2008/2009 crash unnerved everyone. The 50% drop during the 2000 tech crash took two years to grind out, but this time around it only took 9 months to plunge the same percentage. This was excruciating for many people. Quite a few people I know bailed out of the market in the months before the March 2009 bottom. A Merrill Lynch broker I spoke with said 5% of his clients capitulated during that period, and I suspect that was a good track record.
Why has the market become more volatile? Some analysts rate the 2008/2009 financial crisis as a once in a lifetime event. Others believe that higher volatility will be the new normal. The more volatile crowd asserts:
- The world has become much more interconnected. International markets now track within milliseconds.
- ETFs have transformed traditionally illiquid or hard to access asset classes (e.g., commodities, bonds) into stock-like instruments that are much easier to buy and sell.
- Sovereign debt, including US Treasuries have become return-less risk. At current prices/yields they aren’t attractive for diversifying a portfolio.
- Heavy volumes in futures trading (e.g., S&P E-minis) and ETFs (e.g, SPY,IWM, QQQ) are increasingly driving the prices of the stocks that comprise them, not the other way around.
The likely effect of these changes is to increase the correlation of the markets—everything moving in unison. And when correlation increases, volatility increases too. Asset classes that used to move independently, or in opposition to each, now reinforce. Unfortunately we can’t prove who’s right about volatility—the world won’t hold still while we run experiments. However there’s one trend that strongly supports the increased correlation theory—a statistic called implied correlation.
The CBOE has an index that tracks the implied correlation of the S&P 500. It evaluates the market’s volatility expectation for 50 individual stocks compared to the expected volatility of the overall index. The implied correlation will be high if the expected volatilities of the subset are similar to the expectation for the index.
Differing expectations between the subset and the index result in a low implied correlation. For example, if most of the individual stocks (e.g., Exxon) are expected to be quiet and the overall index is expected to be volatile then the overall implied correlation is low. The index uses the implied volatility (IV) of options on the various securities compared to IVs on the index itself to make this calculation. The chart below shows the CBOE’s implied correlation over the last 5 years.
Clearly the options market is expecting correlation to increase.
If the market continues to be volatile we’ll have the following issues:
- Many people won’t invest. The market (and the media) will scare them away
- Buy and hold investing will give poor results. Volatility is not conducive to compound growth.
- New ways of investing that profit from volatility, or at least mitigate its impact will need to be developed
At the recent IndexUniverse’s Inside ETFs Conference I had the opportunity to talk with Jim Lonergan, CEO of The Connors Group. One of The Connors Group’s products is specifically targeted at the issues above—it’s called The Machine®. Using 11 years of historical data, and backtested trading strategies, this software takes the emotion out of trading by objectively generating buy and sell signals for your portfolio. The package supports a multitude of different trading strategies, many of which are designed to move the investor into cash during a market down-swing. I’ve been using The Machine for two months, and I’ve been impressed. The setup is straightforward, and it leads you step-by-step through the initial decisions you need to make:
- Define your asset allocations (e.g., percent in bonds, cash, gold, equities)
- Select your trading strategies (e.g., risk parameters, drawdown percentage, frequency of trades)
Once you’ve made your choices the software automatically backtests your selections to simulate how your portfolio would have performed in the past.
Of course this is no guarantee of how things will go in the future, particularly since things like inter-security correlation is changing, but it’s a reasonable view of what to expect. The screenshot below (click to magnify) shows my portfolio allocations and strategy selections.
Next are the simulated results.
The backtested 10.50% compounded growth compared to the S&P500′s 3.55% is pretty impressive.
If you like your setups you can make the specified investments, and then follow the recommended buy and sell signals. The Machine has network linkages available to broker dealers including Lightspeed Trading LLC, OptionsXpress Institution, and TradeStation Securities if you want to automate this part of the process.
Looking at the backtest results, you can see that the real advantage in my portfolio was the downside protection. During the majority of the critical September 2008 through March 2009 period The Machine would have kept over 60% percent of my portfolio in cash.
The remaining investments would have returned +38% (!) during the crash.
I don’t think automated trading will be the only viable approach to taming volatile markets in the future. But I’m convinced we need new approaches to investing that take human subjectivity out of trading, and attack volatility head on, instead of trying to ignore it.
The market has changed.