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Softening Hedge

141024allocations

Our Market Risk Indicator cleared its warning this week. However, our core measures of market health are still mired in negative territory. As a result, we’ll be softening the hedge in the hedged portfolio and staying 100% in cash in the long/cash portfolios. To soften the hedge we’re removing put options and/or volatility products. For the model portfolio we’re selling ETFs or ETNs like VXZ, VIXM, or XVZ and replacing it with at short of the S&P 500 Index (you can use the symbol SH). The end result is a portfolio that is roughly 50% long stocks we believe will outperform in an uptrend (high beta stocks are likely candidates for the hedged portfolio) and 50% short the S&P 500 Index. Below is a chart with the changes in our portfolio allocations over the past year. Green lines represent adding exposure, yellow lines are reducing exposure (and adding SH as a hedge), red lines are market risk signals where the hedged portfolio uses instruments that benefit from increasing volatility as

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Market Risk Update

141022marketrisk

Our market risk indicator warned on 10/10/14 and since that time the market has dropped and recovered in an extremely sharp V formation. The quick move is causing the indicator to whipsaw on a daily basis. It has been moving back and forth between warning and clearing the warning. If the market doesn’t fall sharply between now and Friday I expect the warning to be cleared which will cause a whipsaw hedge signal as discussed in this post. With that said, the picture is still cloudy so we’ll have to wait until week’s end for clarification. As always, I’ll post before the last hour of trading with an official call (and any portfolio allocation changes). One point on the issue of whipsaws. Please be aware that this indicator is specifically designed to warn of the heightened possibility of quick drops in the market. It has a good record of warning before big declines, but also has a lot of whipsaws. As a result, we use it mainly for a signal to

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What Next?

141017MarketRisk

Our Market Risk Indicator signaled last Friday in the last hour of trading which caused us to add an aggressive hedge to the hedged portfolio. I have to say that I was surprised to see an acceleration of the selling without some consolidation near the 200 day moving average for the S&P 500 Index (SPX) first. The reason for my surprise is that the market had already fallen sharply before the signal came and that condition often causes whip saws in the indicator. The market has since recovered much of the decline from earlier in the week. So what do we do next? If the market continues to rally I suspect that our risk indicator will clear its warning within a week or so (similar to the whip saws in March and June of 2011 on the chart below – Note: red lines are risk signals, blue lines are cleared warnings). If this happens then we’ll change our hedge back to a simple short of the S&P 500 index (using

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Moving to Cash or Full Hedge

141010markethealth

The volatility in the market over the past week was accompanied by a deterioration in all of our core market health indicators. Every category is now negative. As a result, our long/cash portfolio allocations are now 100% cash. Our hedged portfolio allocation is 50% long stocks we believe will out perform the market in an uptrend and 50% short the S&P 500 Index (ticker symbol SH). Please note that this isn’t a prediction of a market decline. Instead it is simply acknowledgement that enough things are wrong with our underlying indicators that I feel it prudent to step aside until the indicators give clear positive signs. UPDATE 3:32 PM Eastern – OUR MARKET RISK INDICATOR SIGNALED AFTER THIS INITIAL POST. AS A RESULT, OUR HEDGED PORTFOLIO WILL USE AN AGGRESSIVE HEDGE. Our Market Risk Indicator is very close to a warning, but it hasn’t yet (2 PM Eastern). It will take a steep sell off in today’s remaining trading session to create a signal. If it signals before the close

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Due for a Bounce

141001nyad

Our core measures of risk are very close to going negative. If they make it below zero by Friday we’ll be raising more cash and/or adding a larger hedge. Our measures of market quality and strength are also falling, but they’ve got a bit more room before going negative. With that said, the market is due for a bounce so conditions could change quickly.  I’ll do a post on Friday well before the close with any changes to our portfolio allocations. This decline is different in nature than the previous two this year in that it appears to be more about portfolio positioning for the longer term than fear (of any kind). The most sensitive components of our Market Risk Indicator aren’t being severely impacted while the slow moving components have rounded out tops and moved below zero. Our core measures of risk (that are completely independent of our Market Risk Indicator) have mostly been diverging with price since the end of last year and are now close to going

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We’ll Have to Wait Another Week

140801markethealth

Over the last week most of our market health indicators fell slightly, but didn’t suffer enough damage to make any changes to our core portfolios. Our measures of risk showed a large amount of concern from market participants, but didn’t fall below the zero line. Our Market Risk Indicator has two of the four components warning. The other two components moved rapidly toward signaling yesterday, but have backed off a bit today. As a result, our risk indicator shouldn’t warn today unless the market falls sharply in the last hour. One interesting thing of note is that our risk indicator almost never signals without at least one of our core indicators warning as well. The only instance since 2000 was on 9/19/2008. With modest strength in our core indicators and no risk signal our portfolios will remain 100% long for at least another week. Any changes next will will almost certainly be a result of a continued decline that triggers our risk indicators. Below is a chart with our current health

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Market Risk Rises While Health Improves

140725MarketHealth

Over the past week our indicators are showing more risk entering the market while most of our core health indicators are improving. This is a change from the past 18 months where risk entering the market has been associated with deterioration in our core indicators. This signals a change in the character in the market that we should watch closely. Market participants are now starting to show concern about world events and earnings misses. In the past, earnings misses were considered company specific and didn’t have much impact on the market. This is something to keep an eye on. Since our core indicators are all positive we’re still 100% long in all portfolios. Any changes over the next several weeks will almost certainly come on the back of an “event” or a severe down turn. In the absence of a sharp market decline I doubt we’ll have any changes. Below is a chart of our core health categories.

 
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Market Health Rises – So Does Risk

140718MarketHealth

Over the past week market health rose, but every measure of perceptions of risk rose too. It speaks to the current theme in the market where core indicators are rising and ancillary indicators are falling. While the underlying health of the market wasn’t affected by this week’s volatility it did do some damage to market participant confidence in the market. Our core measure of risk along with our Market Risk Indicator have slowly been moving closer to warning. At the moment they have plenty of room above the positive line so they aren’t overly concerning, but something to keep an eye on in the next few weeks. Below is a chart with our core health categories.

 
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Make or Break Time

By almost all the measures I track it’s make or break time for the market.  I’m seeing a pattern in both core and ancillary indicators that has often marked lows in the market over the past few years.  Each time our indicators were close to signalling an extreme warning the market promptly turned back up and resumed the rally out of the 2009 lows. Over the longer term when our indicators have reached these levels the market rallied 35% of the time and had an extended decline or choppy period 65% of the time.  As you know, I can’t see the future so all we do is go with the odds.  As a result, our core portfolios raised cash and/or added a hedge yesterday.  Here are some highlights of things I’m seeing that makes me cautious. The ratio between near term volatility (VIX) and 3-Month volatility (VXV) is currently rising as a result of both VIX and VXV moving up.  This is a condition that has only occurred a few

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More Thoughts on the Volatility Hedge

I got a few questions about the volatility hedge strategy that I mentioned yesterday that provoked a few thoughts  I thought might interest you.  The first thought is that there is no need to go all the way to 50% hedged with XVZ (and 50% long) when our market risk indicator signals.  I personally use a large hedge when it signals because the indicator is designed to warn of an acceleration to the downside.  As a result, I’m willing to give up some upside gains on whip saws for the chance of making money if the market falls rapidly…and volatility rises.  However, I recognize that you may have different goals than mine so here’s a performance chart that shows varying sizes of the hedge.  Notice that a hedge below 20% (80% long and 20% XVZ) would have resulted in the portfolio continuing to fall with the market during the 2008 financial crisis.  However, during a large swift draw down a 20% hedge with volatility was enough to protect the portfolio

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