Volatility Matters

We have mentioned before in this weekly email blog that volatility plays a central role in our trading strategies and we believe it provides a unique edge that can earn above average returns with a low correlation to the market. One example is the last long stock market position (TQQQ) held by the Forte Strategy that was exited on February 27, three weeks before the market bottom on March 23 and avoided a painful 30% decline (we’ve traded the gold and oil markets a few times since then, but still no stock market positions as volatility remains high as shown below).

This week we studied the market volatility generated by the COVID19 pandemic within the context of other historic bear markets. For the purposes of this study, a bear market is defined as a spike in volatility that is four times greater than the total volatility of the Dow Jones 30 for the period from 1985 to the present. We used a simple definition of volatility as the 10-day moving average of the standard deviation of open-high-low-close prices divided by today’s closing price. The graph below shows that there have been six volatility spikes greater than four times that average over the past 35 years resulting in an average market decline of 34%:

20200529_chart1

Then, we considered the aftermath – how does the market perform after a 4X spike in volatility? And more importantly, what does it possibly suggest about the future of today’s market (if anything)? The table below summarizes the data for peak-volatility events meeting this criteria:

20200529_chart2

A few observations can be made from this data table. For one, there are only two examples of a V-shaped recovery, the Russian Debt Default (1998) and September 11, 2001. Both of these where fairly isolated events and experienced about half of the magnitude of the volatility spike of the three major global events (Black Monday, the Financial Crisis, and the COVID19 Pandemic). Also, within less than 40 days after these two spikes, market volatility had returned to normal. And, in all cases except for the 2008 Financial Crisis, the volatility spike was at or near the market bottom. Lastly, the post-spike market performance of today’s market is the most bullish 30 and 60 days ever realized after a peak volatility event. This is an outlier compared to all prior events, especially the other two large spike events, Black Monday and the Financial Crisis, which were either flat or declined during the 30 – 60 days following the spike.

We’ll narrow our study to three large, global events where the volatility spiked 7X or more: Black Monday (1987), Financial Crisis (2008), and the COVID19 Pandemic (2020). The graph below shows the overlay of these three time periods. The lines show an uninterrupted series of days where the volatility was at least 10% higher than the average. It’s interesting that, by using this definition, you can see that the markets become volatile at least a month before the peak sell-off and it was another 4-5 months before the volatility returned to a normal level. The last data point for the COVID19 line is Thursday, May 28 where the green line is sloping upward and is at the highest level over the last month.

20200529_chart3

The graph below shows the market performance before, after, and during the volatility spike. The start and end points of the graph are when market volatility was at least 10% higher than the average leading up to and after the major spike event. You can see that both Black Monday and the Financial Crisis both had a 2nd wave of market declines that came near the spike bottom or exceeded it even though the volatility remained below the 4X threshold after the initial spike greater than 7X.

20200529_chart4

As we worked on this research, it prompted several ideas on a new trading model structure that is based solely on volatility. It’s compelling that the market volatility was elevated at least 10% above average at least three to four weeks prior to the major sell-off and then remained relatively high over the following four to five months. As stated in the opening paragraph, this has been the case with our current trading model for the equity markets which are, however, currently more complex than a simple in/out approach based solely on volatility data.

So, what does this analysis suggest for today’s market? We believe that, given the scale of the March volatility spike and striking similarities of the patterns compared to Black Monday and the Financial Crisis, we’ll see a second leg-down sell-off in the market which will come within 10% of the March lows and possibly exceed the low as that we saw during the Financial Crisis. At a minimum, the volatility will persist for another six weeks and likely up to the November elections; however, a lot has changed since 1987 and 2008 as we now see quick and active intervention by central banks around the globe with a seemingly infinite ability to create money, willingness to distribute to the populace and purchases assets in the open markets (in some countries). Although the first 60 days of this bear market look quite similar to 1987 and 2008 progressions in some ways, there is some chance that the intervention by the central bankers explains the unprecedented bounce seen in the first 30/60 days and this level could be sustained from here or even accelerated.

Forte Strategy Update

Here’s a short update of the Forte Strategy trading activities for the week. The equity markets remained at elevated levels of volatility for the week which left these trading models inactive; however, the volatility for the gold and oil markets remains at a level where trading models are active. We executed four trades in the gold and oil markets which netted a loss of 0.6% for the week which created a total loss for May to 0.7%. Our full year net results so far equal a 2.0% loss compared to a 5.8% year-to-date loss for the S&P 500. More details about our trading activity can be found by registering on the Collective2 website and searching for Forte Strategy. A running list of these email blogs and general information about Maestro Capital Research can be found at maestrocapitalresearch.com.

Please continue to stay safe and healthy.

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