A New Risk Indicator To Sidestep Market Downturns: Is It Better Than VIX?

By Chris Georgopoulos, originally published on 11/14/11

Without question the most popular model to predict market crashes is the VIX, commonly referred to as the “Fear Gauge,” a market index that measures the implied volatility of the S&P 500 index options. Its concept is quite simple, when the uncertainty and fear among investors rises, they commonly run to the S&P 500 options to either hedge or speculate. The increased interest in the options usually leads to higher premiums and as the premiums increase so does the VIX. However, predicting the future isn’t 100% accurate, most of the time it’s not even close. Every forecasting model has its flaws and the VIX is not an exception. There are many problems skeptics have found with the VIX such as; its population study is limited to only the 500 stocks of the S&P 500 and” {the} model is similar to that of plain-vanilla measures, such as simple past volatility” (Wikipedia). A blog post on sensibleinvestments.com summarized the VIX as “simply an indicator of actual volatility in the market but one that is very sensitive to changes in actual volatility particularly if it is on the downside.” Is there a better way?

An elementary statistics theory states that the larger the population size, the greater the likelihood that the sample will be represented. If markets are graded by the performance of popular indexes such as the S&P 500, why limit a forecasting model’s population to only 500 stocks? The economy has become global; interactions from every corner of the world’s businesses affect every other business. If there is a model that forecasts market direction, should it limit itself to just the largest companies? As for only using a month or two of short term option premiums to garner a prediction, as the VIX does, it seems to limit itself to only a single variable. Instead of short term options premiums and limited samples what if we could measure real-time individual stock trend alerts on thousands of domestic and foreign stocks and ETFs? Or simply what if we analyzed the micro components (every stock) to develop a macro forecast of the market based off trends and risk?

By studying the history of risk alerts from SmartStops.net, an intelligent risk management service, two proven alternatives to the VIX were found. SmartStops.net has developed their own proprietary risk model that monitors the trends and risks to over 4,000 of the most popular stocks and ETFs. If the risks grow on any individual investment SmartStops.net alert their subscribers with both long and short term exit triggers. However not only do these alerts help individual and institutional investors manage specific investment risk, the reviews of the alerts themselves have predictive capabilities. By back-testing every alert that SmartStops.net has issued from their inception versus the S&P 500 performance, there is proof of this and the results speak for themselves.

There have only been 7 days for which the amount of Long-Term Exit Triggers (stop alerts) as a percentage of every stock and ETF covered by SmartStops.net has been over 20%. The subsequent market action of the S&P 500 has averaged a negative return for the time periods of 1 week, 1 month, 3 months, 6 months and a year. The 6 month average return is over -7% and when examined from the absolute lows of the S&P 500, the returns average over -19%. If you remove the knee-jerk market reactions caused by “Flash Crash” on 5-6-2010, the returns are even lower.
Another metric offered by SmartStops.net is their SRBI(tm) (SmartStops Risk Barometer Index); this index measures the current percentage of stocks and ETFs that are in “Above Normal Risk” state (ANR) divided by the 100 day average above normal risk percent. By definition, a stock that is listed ANR experienced a risk alert as its last SmartStop alert identifying a downtrend. Conversely, a stock that is listed in a “Normal Risk State” experienced a reentry alert as its last SmartStop alert indicating trading strength and an upward trend. Back-testing historical SRBI data since inception shows that the repercussions to the market when the percentage of downtrends increases to over 40% of all stocks and ETFs covered are profound. Below you will see that there have been only five occasions where this has happened. In each case the S&P returns for the following year were all negative.

Is this a better way?

Before a concrete conclusion can be determined, the predictive capabilities of the VIX must also be analyzed.

Tax Loss Harvesting – using sector ETFs to continue the exposure

originally posted at ETFTrends:

 

Many financial advisors use low-cost, liquid exchange traded funds in tax-loss harvesting strategies that can offset future gains and cut clients’ tax bills in the long term.

Talking about underwater positions is never fun as the end of the year approaches but realizing losses has a “silver lining,” said Rande Spiegelman, vice president of financial planning at the Schwab Center for Financial Research, in a conference call with reporters Friday.

“The good news is losses can be used to lessen the tax bill and position for next year,” he said.

Realized losses can be deducted from ordinary income by up to $3,000 a year, while any additional losses can be used in future years.

However, investors need to be aware of the “wash-sale” rule. Investors cannot claim the loss if they buy a “substantially identical” security within 30 days of the sale.

This is where ETFs can help out if investors want to keep exposure to the market.

For example, an investor may be sitting on a loss this year on a financial stock, explained Michael Iachini, managing director of ETF Research at Charles Schwab Investment Advisory. The investor can sell the stock and take the loss, but they might miss any rebound rally in the financial sector over the next month.

To maintain exposure to the sector, the investor could buy an ETF indexed to financial or bank stocks, Iachini said on Friday’s call. ETFs are a “good fit” for the strategy if investors don’t want to be out of the market for a month.

Some financial advisors use tax-loss harvesting strategies featuring ETFs that track the same sector but are pegged to different indexes.

The IRS hasn’t provided a hard definition of “substantially identical,” and investors should consult a tax advisor about the wash-sale rule.

Also, investors need to consider any ETF commissions or other trading costs associated with the strategy.

Finally, Schwab’s Spiegelman said not to lose sight of the overall investment plan and let the “tax tail” wag the dog. “Don’t upset the long-term investment plan or asset allocation just to get a tax break,” he said.

“ETFs have made tax loss harvesting a lot simpler than it used to be,” said Charles Zhang of Zhang Financial in a recent Reuters report. “It’s not that hard to find one that’s a good stand-in.”

In Defense of Market Timing – a study that will shock you!

SmartStops comment :  As we dig up other studies we’ll add to article.  

Missing Best and Worst Days in Stock Market 1984-1998

 The article was originally published in 2008.    

SmartStops  comment  on 08/4/11:    Markets have dropped 9% in last nine days with the whole debt ceiling “show” going on in U.S.  government.   Do you think you needed to have given back your gains?   Think again!

Market timing is the art of making investment decisions using indicators and strategies to observe and determine the direction of prices. Many believe that market timing involves predicting the future, when in reality, the goal of market timing is to participate in periods of price strength and avoid periods of price weakness.

The general investing public has been told that market timing is a high risk proposition. Most of what has been written about the topic focuses on its failure and the risk investors take when trying to time the market. A typical study focuses only on the negative consequences of missing a few particular up days in the market – calculating the negative financial impact of missing those days and concluding that attempting to time the market is foolish. The biggest fallacy with these studies is   

ETFs And Allocations To Protect Portfolios In The Current Financial Storm

excerpt from article at Seeking Alpha: 

 This is a followup to a previous postings suggesting how investors can take refuge in the oncoming financial storm. If you’ve not done so already, be sure to read my previous post Say It Ain’t So for a description of our dismal macroeconomic picture.

The purpose of this article today is to explore any safe havens for your investments to shelter them from this worldwide slump. What are we protecting against? Problem is, we don’t yet know. And we won’t until the elections play out next year, and events in Europe unfold.

The market may not wait for the politicians. Technical indicators suggest a very large correction in the market can be expected, and fundamental macroeconoomic trends unfortunately offer no consolation.

How severe will the downturn be?

In my view, that will depend in part on what fiscal and monetary policies we pursue, and how international political relations progress. There my crystal ball is a little cloudy.

Scenario one sees a continuation of monetary easing, as pursued by both the Bush and Obama administrations, and largely aped by European governments to a lesser degree.

In this scenario, the policy response will be pure Keynes, with large bouts of government spending to build out our country’s infrastructure and hopefully create jobs. The Fed will assist with gobs of money dished out to offset rapidly deleveraging private expenditures and to support our wobbling real estate market.

for rest of article, click here

The New Oil Dynamics

originally posted by Tony Daltorio at http://wallstreetmess.blogspot.com/

The oil market changed back in 2009, but most Americans did not notice.

That was the year, for the first time, China temporarily surpassed the United States as Saudi Arabia’s biggest and most important customer.

At the time, Saudi oil minister Ali Naimi said “Ten years ago, China imported relatively little crude oil from us. Now, it is one of our top three markets, and is the fastest growing market for us globally.” He added that this showed the increasing “depth of Saudi-Chinese relations”.

Today, when oil tankers leave Saudi ports with their load of crude oil, they increasingly travel eastward to the rapidly growing economies of Asia rather than to the established markets of western nations.

When looked at historically, this new trend is significant. Remember that the most of the oil industries in the Middle East were originally set up by western companies with the sole aim of providing oil for western economies.

The day when Saudi oil exports to China permanently overtake those to the U.S. has not arrived yet.  But it will soon.

ETFs Turn Exotic – Protect yourself

Source: McGraw-Hill Financial Communications

Investments that do not move in tandem with U.S. stocks present opportunities for diversification and potential performance enhancement.

Summary Points

• Exchange-traded funds (ETFs) are a convenient vehicle for accessing a variety of investments other than stocks.
• Alternative investments include hedge funds, commodities, derivatives, and real estate.
• In addition, there are alternative investment strategies that encompass short selling, arbitrage, leverage, and futures.

Of the top-selling ETF strategies to emerge on the scene in 2011, many present investors with choices other than U.S. equities. For instance, an ETF investing in Asian debt topped the list of launches with $470.98 million in net flows as of June 30, while a managed futures strategy fund came in second with $192.72 million in net assets.¹ Other funds making the top ten include an ETF investing in senior loans and a fund investing in real estate investment trusts (REITs).¹

What’s behind investors’ attraction to these more sophisticated, and in some cases more risky, investment choices? People are looking for something besides a plain vanilla fund, something that puts them outside the universe of U.S. Treasuries and domestic equities. They are looking to diversify their portfolios globally as well as thematically via commodities, emerging market debt, and hedging strategies such as managed futures. Managed futures funds invest in listed futures and options to benefit from expected trends in commodity prices, interest rates, or currency exchange markets.

What’s driving investors’ attraction to the exotic is a desire for investments that historically have not moved in tandem with U.S. stocks.

Hedge fund leverage in the industry – how its grown

SmartStops comment:   Who watches out for the little guy?

A chart from MIT’s Andrew Lo of the growth of assets and hedge fund leverage over the last 20 years. You can see the expanding leverage in the 2001-2005 period.  originally posted at Infectious Greed blog.

Hedge_Fund_Leverage how-its-grown

Chicken or Egg? Risk Tolerance as a Driver of Financial Success

SmartStops would like to draw your attention to this article’s statement:    Overall, by taking more risk Bill can expect to be significantly better off.    As SmartStops will remind you, you can take on more risk by ensuring there is constant active oversight for it.  See other articles on that subject.   

 published originally at:  Advisor One by Geoff Davey, FinaMetrica

Many studies have shown that risk tolerance correlates positively with income and wealth. The correlations are not strong, usually around 0.3, but they seem to be universal.

There is a temptation to think that higher income and/or higher wealth lead to higher risk tolerance. However, there is always a danger in trying to read a cause and effect relationship into a correlation. To know for sure we would need to conduct a longitudinal study measuring risk tolerance, income and wealth as we went along.

Failing that, we can conduct a thought experiment. Suppose that Bill and Bob have different appetites for risk. Presented with a choice between taking a certain $100 and a 50/50 gamble of winning $0 or $X, Bill will take the gamble when X is $250 but Bob won’t take the gamble until it reaches $300. Looking at any single $250 gamble choice, Bill has a 50% chance of being no worse off than Bill.  However, if Bill and Bob are presented with a series of such choices, the longer the series runs the more certain it is that Bill will finish up better off than Bob. With a series of 10, Bill has an 83% chance of being no worse off than Bob and by the time we get to a series of 100 that chance has increased to 98%.  Over 10 choices, Bill will finish with $1,000 but Bob could expect to have $1,250, though he may have nothing or $2500.

Now suppose that Bill and Bob both started with a kitty of $1,000 and that rather than the choices being framed from a base of $100, they were framed from a base of 10% of the kitty at the time. For 10 choices, Bob’s kitty grows to $2,593 but Bill’s grows to an expected average of $3,260 and 62% of the time will be greater than $2,590. At worst Bill will have $1,000 and at best $9,300.

Overall, by taking more risk Bill can expect to be significantly better off.

So how does this relate to real life? Clearly, life’s choices are rarely as simple as in our example and rather than a series of identical choices we face a series of mainly different choices where there are usually more than two alternatives—and those alternatives will often include the possibility of losses. Further, the range of outcomes is often not clear and they must be estimated rather than calculated. Finally, we may make cognitive errors in assessing the situation and in identifying and evaluating the alternatives.

As we know from experience, risky choices take many forms and occur in different contexts including employment, borrowing, insurance and investment. For the riskier alternatives to be considered there would be a commensurately greater expected reward, but this will come with the possibility of an unfavorable outcome. The more risk tolerant amongst us will need less of an incentive to take the riskier alternatives. If we continue that pattern over time, all other things being equal, we should finish up better off.

So my hypothesis is that risk tolerance is a driver of financial success rather than the converse.

European Default Inevitable — Sell Your Gold?

By Christopher Georgopoulos

 What if, hypothetically, fear of a Greek default cannot be contained? What will be the aftermath to the markets? To gold?

 In the prequel to this article (European Default Inevitable — Sell Your Gold?), I discussed the fact that safe-haven-seeking investors could be in for a surprise when they run to buy gold after a Greek default and find huge sellers in the form of European sovereign nations. That article focused on events that would occur if a Greek default could be contained and the contagion that’s brought so much fear to the global system could be defeated. But what if, hypothetically, that fear cannot be contained? How will it happen, and what will be the aftermath to the markets? To gold?

The first signs of a detrimental contagion will be surprise losses, initially centered within the European banks and financial institutions. Articles such as, “European Stress Tests Underestimated Greek Exposure” will catch front-page attention. Quickly after, multiple small banks will become insolvent and the names of those banks — which many Americans have never heard of — will become as well-known as Citibank (C). Those defaults will spread to the larger European institutions that many of us know, and emergency midnight conferences will be highlighted on CNBC wherein the global financial community will be assured that all is sound. Sooner than later, a major default of one of these institutions will be revealed, and the bomb will be detonated.

This is when a 2008-type Lehman event reemerges, but this time on steroids. The fear driven from individual financial institutions will quickly morph into a fear for the nations of Europe. This fear will be derived from the recent questions concerning the lack of growth to combat their immense debt-to-revenues ratios. Anyone holding the bonds of these debt-ridden countries (i.e. Ireland, Portugal, Spain, and Italy) will panic and sell, driving their yields even higher and their credit-worthiness even lower. Those countries will find that trying to fund their needs through bond markets has become even harder and more expensive, and their risk of default will skyrocket. Deep recessions will set in as they will impose even deeper austerity plans, and unemployment — already high — will grow. Because these country’s economies are co-dependent upon each other as trading partners and consumers, even the more financially stable countries will be adversely affected. The viability of the entire Union will be questioned, their currency devalued, and talk of secession will be popular. Even worse, the spread of these losses will not be restricted by their coastal boundaries. Many American and global banks still have exposure to their European counterparts as well as money market and mutual funds. New losses, which could include massive losses on European credit default swaps, must be accounted for, which could cause a new round of credit freezes. Just like a repeat of the 2008 financial crisis, the foundation of the rapidly spreading fear will be a lack of confidence. Although this time around the solution won’t be as easy: Who will have the money to back-stop the back-stoppers?

If this were the scenario, the panic that the markets around the world would experience would be historic. The first wave of heavy selling (besides the aforementioned European bonds and stocks) would be centered in your most risky investments — the high-yielding and high-return emerging markets. Equities of the most stable markets would quickly follow. Money would flow from there to the “safest” of investments, such as US treasuries, US currency, and gold. As mentioned in my previous article, the price of gold would initially fall as Germany and the ECB try to contain the Greek default, but if the world’s confidence erodes and the defaults spread, the gold markets would once again be one of the few safe alternatives and could offer substantial upside.

The coming volatility of the markets could be unprecedented and swift. My firm has highlighted that the risks of serious market deprecation are likely with its SmartStops Risk Barometer Indicator.

SmartStops Risk Barometer Indicator (SRBI)

You need to monitor the SPDR gold Trust (GLD), SPDR S&P 500 (SPY), Rydex Currency Shares Euro Trust (FXE) and the Vanguard MSCI Europe ETF (VGK).

Valuations in Free-Fall: S&P 500 Cheapest Since 1957!

 originally published at Kapitall, who go on to identify potential stocks to play.

The Standard and Poor’s 500 index valuation has hit 25% below the average from the last nine recessions, even as price estimates continue to fall, according to Bloomberg‘s data. These estimates provide a statistically significant outlook on analyst expectations for future growth and the degree to which stocks might be considered undervalued.

Historically, market contractions have not reached these lows since 1957 when the gauge for American equities traded at 13.7 times forecast earnings. Today’s equities trade at 10.2 times 2012 forecast earnings and earnings estimates continue to fall to their lowest level since April.

“What you’re seeing is a growth scare,” Wayne Lin, a money manager at Baltimore-based Legg Mason Inc. “The question is, how much of that is priced in. I’d say that if we don’t have a double-dip recession, if earnings just stay flat, these valuations are reasonable. The market already expects those downgrades.” (via Bloomberg)

Unlike previous market crashes or recessions, this one has been relatively slow-going. In the previous nine quarters, companies prepared for further economic volatility and managed to exceed income forecasts after cutting costs and lowering debt. With lowered analyst estimates for 2012 companies will have an easier time hitting their mark.

Whether or not lowered earnings estimates makes today’s stock prices a bargain is an ongoing debate between bears and bulls. According to Rob Arnorr, founder of Research Affiliates LLC, “the measures by which stocks are cheap today rely on continued recovery and a continued surge in already peak earnings. It relies on a very shaky foundation.”

for stock picks, go  to Kapitall.