With the sell off this morning I’m taking the opportunity provided by a spike in volatility to take some profit from the hedge and soften it in the Long / Short Hedged portfolio. I’m taking all profit from the hedge and buying new long positions with it. In addition, I’m selling 1/3 of the aggressive hedge (mid term put options, VXZ, or XVZ) and buying a short of the S&P 500 Index (or using SH). Usually, the longs in the portfolio have dropped enough that the new allocations are fairly close to a 50% long and 50% hedged position after a rebalance. But due to the large increase in volatility without much price damage in the market since 8/21/15 (when my market risk indicator signaled) the new allocations have a slightly smaller hedge than is normal after a rebalance. The new allocations for the Long / Short portfolio are as follows. 53% Long stocks that I believe will outperform in an uptrend (high beta stocks) 15% Short the S&P 500
Many people have the mistaken idea that high volatility (VIX) means falling markets. They’ve been trained by financial news outlets to associate volatility with fear. This notion is only half right. Volatility is also connected to greed. In reality, volatility is a reflection of the size of a price movement regardless of the direction. Take a look at the chart below and you’ll see that during the late 1990s price was rising, but in wide daily ranges. This caused VIX to rise substantially while the market was going up. VIX went up from about 10 to 27 (170%) while the S&P 500 index (SPX) almost doubled from late 1995 to just before the Russian financial crisis of 1998. So without much “fear” in the market VIX nearly tripled. After the Russian financial crisis VIX stayed elevated in a range between roughly 19 and 30 as SPX climbed 38%. Large range days while the market was rising created an elevated VIX. SIDE NOTE: I’m using VIX to show the price move
Just a quick note about the portfolio allocations and the current market health indicator readings. All of my core health indicator categories rose this week, but they’re still mired in negative territory. In addition, my market risk indicator is still signaling. As a result, the core portfolios remain aggressively hedged with an instrument that benefits from higher volatility (mid term put options, mid term volatility — VXZ, dynamic volatility — XVZ, etc.). I’ll do an in depth post with my thoughts on the market later today that will highlight VXZ. Here’s a preview chart. Notice that the S&P 500 Index (SPX) has retraced it’s decline from last Friday’s close, but VXZ is still up 15% from Friday’s close. Volatility begets volatility…which is why mid term volatility makes a good hedge during fast moving markets.
The monthly chart of the S&P 500 Index (SPX) now has monthly momentum below 100. This condition needs to right itself before the end of the month or the odds will increase that we’re starting a longer term bear market. Just one more domino to fall for the long term bull market.
My market risk indicator is warning today. That changes the portfolio allocations of the Long / Short portfolio and the Volatility Hedged portfolio to 50% long high beta stocks and 50% aggressively hedged. An aggressive hedge is a vehicle that benefits from higher volatility such as put options, or volatility ETF/ETNs like VXZ or XVZ. Please note that XVZ is thinly traded so limit orders (and likely several small purchases) would be prudent. Use your own discretion in which product you use…and as always never buy a product you don’t understand. If you’re using put options our portfolio allocations indicate that you should fully cover your portfolio at or near the money. Use your own discretion in term structure, but be aware that I look to mid term (4 to 7 months) puts first. If you’re uncomfortable with volatility or put options an actively managed bear fund like HDGE is a short option to use as a hedge. It will likely offer more protection than a simple short of the
As a technical analyst I love it when independent chart patterns suggest the same resolution in the market. I’ve been highlighting two important chart patterns over the past month that will tell us if the market will eventually resolve in a rally or a decline. Yesterday both charts broke below their trigger lines suggesting a fairly large decline is ahead of us. The first chart is of the S&P 500 Index (SPX). It has been painting a tight line for most of the year. It finally fell below the bottom of the range. This break projects a minimum downside target of 1940 which would be about a 9% decline in total. I’m guessing that we’ll finally get the long awaited 10% projection. The second chart is of the Dow Jones Industrial Average (DJIA). It has been painting a rounded top pattern. Yesterday it broke below 17075. This break projects a minimum downside target of 15825 which would be a roughly 13.5% decline. From a Dow Theory perspective a decline to
Over the past week my measures of market health bounced around with some gaining and others falling. Most notably, measures of market quality fell below zero. This changes the core portfolio allocations to the following. Long/Cash portfolio: 100% cash. Long/Short portfolio 50% long stocks that I believe will outperform in and uptrend — 50% short the S&P 500 Index (using SH or a short of SPY). My market risk indicator is still reluctant to warn. The two least sensitive components have flat lined over the past several weeks. They have been moving slightly just above or below zero. The most sensitive components are are compressing in a range well above zero. This leaves the volatility hedged portfolio 100% long. Basically, the market is on dangerous underpinnings, but price hasn’t broken down. My market risk indicator is telling us that market participants are waiting for a price break before getting concerned. The indexes are painting patterns that can be either accumulation or distribution. They are best characterized as trendless. A great
As you know the core portfolios are almost fully hedged, but the volatility portfolio is 100% long. The reason for this is the core portfolios rely heavily on market internals to indicate everything is healthy under the surface. The volatility hedged portfolio relies on my market risk indicator that is much more sensitive to price. The core portfolios will often hedge during sideways markets because they see damage to market internals that result in chart patterns that can be either accumulation or distribution. My market risk indicator waits until it’s clear that distribution is underway. Currently the S&P 500 Index (SPX) is painting a pattern that can be either distribution or accumulation. We wont know which until the current range breaks. A break above 2140 on SPX would indicate accumulation has been under way and a strong rally should follow. A break below 2040 on SPX would indicate distribution has been occurring which should result in at least a 10% correction. The Dow Jones Transportation Average (DJTA) broke below a
Over the past week all of my core market health indicators fell. My measures of market quality are still hanging on, but fell sharply this week. Although they didn’t go negative this week it is likely they will by next Friday unless the market rallies sharply. The core portfolio allocations remain the same. One thing of note is that the two least sensitive components of my market risk indicator are currently warning. The other two have some breathing room, but they are more sensitive to price moves so a break below 2040 or 2000 on the S&P 500 Index (SPX) would likely generate a market risk warning. In the absence of a market risk warning the volatility hedged portfolio is still 100% long. The current range between 2040 and 2140 on SPX is now six months long. Tight ranges like this one that are only 5% wide represent either accumulation or distribution. By looking only at price we can’t tell which it is until the range breaks. But, looking at
During May of this year a meme spread through the financial world about the under performance of the Dow Jones Transportation Index (DJTA) in relation to the Dow Jones Industrial Index (DJIA). Everyone was talking about the Dow Theory non-confirmation and what it meant for the markets. Today DJTA is still under performing, but the crowd isn’t talking about it. They’ve moved on. It doesn’t matter anymore. Why? Group think. Group think is common in the financial markets (and society in general). An idea that seems reasonable often finds wide support regardless of its merit due to market participants repeating the meme without taking the time to do some independent research or even think about it. When dealing with stock market memes it doesn’t matter if it’s correct it only matters how many other people think it’s correct. Group think moves markets. An example of group think came in early 2013 when a study stating low volatility stocks out perform high beta stocks was widely circulated. This study was repeated