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. For this study the data utilized the same time frames as SmartStops’ data and reviewed two commonly watched scenarios that represent fear among VIX watchers. The first, when the VIX climbs above 40 and the second, the highest closes of the VIX. The results versus the S&P 500 are below.

The VIX does have some predictive properties. The returns from one week up to six months following the move over 40 shows on average negative returns. However, these returns are on average are smaller than the returns using either of SmartStops’ models. Even more compelling, when viewed from the pinnacle of fear (while the VIX peaks), it is only accurate on a 3 month outlook. This proves that not only the VIX is inaccurate predicting longer term moves, but is actually a quality contra indicator for one year returns.

Again, is this a better method of gauging a coming market crash?

It’s hard to argue with the data. Every time the LT exit triggers are over 20% of all stocks and ETFs covered for any given day, the market has fallen. Through the review of the SRBI’s data we see that when the percent in the above normal risk state rises to over 40%, the market has also fallen. The performance statistics are even lower if you take into consideration that among the four thousand plus stocks and ETFs covered by SmartStops, some are inverse ETFs. Comparing this data, the results are not only surprisingly accurate, but have confirmed that both of SmartStop’s market- predicting models work together to predict market crashes.

Compelling losses

Not only is the data hard to argue with but the losses that followed these alerts could be difficult to manage. The average loss for six months is over 15% and over 14% over a full year, but more importantly if we look at the lowest value intra-day price these losses could have amounted to over 35%! These are simply staggering numbers. Imagine the losses if you were heavily margined? Imagine the opportunity costs? Any investor should always be aware of the overall market and these two models can help predict it.

What does the model say about the near future?

In early August 2011 the model gave an unprecedented three alert triggers for both LT triggers of 20% and the SRBI downtrends of 40%. This is the first recorded three alert trigger within five days (8/4/2011, 8/5/2011, 8/8/2011). On 9/22/2011 the intra-day low of the S&P 500 was 1114.22, a 7.15% drop within only a month and a half! On this same day (9/22/2011) two new alerts were triggered. The forecast model has proven its accuracy time and again. Assuming we avoid another “Flash Crash” event, the models expects the market to continue its fall to an average of 15% by February 2012 and 14% by August 2012. Keep in mind, the intra-day lows of the markets could be substantially lower.

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    in the assumption that attempting to time the market will invariably result in missing some important up days. Why should that assumption be made? Where is their study that supports such an assumption?
Then there is the problem of the missing data. That missing data is the data from the study that clearly shows that the benefits of skipping a few of the worst days more than makes up for the potential drop in performance from missing a similar number of up days. This critical distinction is generally not investigated or is deliberately ignored. Unfortunately these studies misinform the public and encourage investors to neglect their
investments in anticipation of riding those big up days, resulting in the acceptance of substantially more risk than necessary. Let me show you the data from one of the major studies used to frighten investors about market timing. This is only one of many studies that purport to show the hazards of attempting to protect your capital. It’s commonly referred to as the “Black Swan” study because it deals with unusual market events (Black Swans and Market Timing: How Not To Generate Alpha, by Javier Estrada, International Graduate School of Management, Barcelona, Spain).

The period in this study encompasses more than 100 years of daily data on the Dow Jones Industrial Average from December 31, 1899 through December 31, 2006. In total the study examines 29,190 trading days. A $100 investment at the beginning of 1900 turned
into $25,746 by the end 2006, and delivered a mean annual compound return of 5.3%. Here are the most widely publicized parts of the study you are most likely to have seen:
1) Missing the best 10 days reduced the terminal wealth by 65% to $9,008, and the mean annual compound return one percentage point to 4.3%.
2) Missing the best 20 days reduced the terminal wealth by 83.2% to $4,313, and the mean annual compound return to 3.6%.
3) Missing the best 100 days reduced the terminal wealth by 99.7% to just $83 ($17 less than the initial capital invested), and reduced the mean annual compound return to −0.2%.

Wow, we wouldn’t want to miss those best days would we? Better ignore market timing and just ride through the declines.

Now here are the parts of the study you may never see because the folks publishing the data don’t want you to know how helpful market timing can be:
1) Avoiding the worst 10 days increased the terminal wealth by 206% to $78,781, and the mean annual compound return by more than one percentage point to 6.4%. (Benefit of avoiding ten worst days is $53,035 more profit vs. risk that missing ten best days might reduce results by $16,738.)
2) Avoiding the worst 20 days increased the wealth by 531.5% to $162,588, and the mean annual compound return to 7.2%. (Benefit of avoiding 20 worst days is $136,842 more profit vs. risk that missing 20 best days might reduce results by $21,433.)
3) Avoiding the worst 100 days increased the wealth by a staggering 43,396.8% to $11,198,734, (Yes, that’s $11 million!) and more than doubled the mean annual compound return to 11.5%. (Benefit of avoiding 100 worst days is $11,172,988 more profit vs. risk that missing 20 best days might reduce results by $25,633.)

Guess what – I like those odds.  But there is absolutely no evidence that market timing will cause us to miss any of those best days. That is an entirely unsupported conjecture. It is very possible to capture many of the good days and avoid many of the bad days with market timing that is less than perfect. Think about this possibility the next time you encounter one of these unfairly biased studies that attempts to show the risks of market timing. Here is some basic advice about market timing that will definitely help. You don’t need to be an expert to be a successful market timer.
1) Keep it simple. Simple market timing strategies work as well or even better than complex strategies, mainly because they have fewer assumptions. By keeping it simple, one doesn’t need to know the ins and outs of Fibonacci retracement levels, Parabolic Stop and Reverse calculations or how to count the Elliott waves.
2) Believe in the importance of trends and the assumption that whatever the current trend direction might be, it is likely to continue. If your market timing efforts are based on simply defining and then staying on the right side of the current trend then you won’t get caught up in trying to forecast tops and bottoms.
3) Know your critical time period for defining trends. If you are concerned about results over a period of years you don’t need to worry about tomorrow or the day after or worry about what happens over the next ten minutes. Give some careful thought to the time period that might have the most impact on your investments, and then learn how to define that trend. What happens over a period of months is
significant even to those long term investors that might be concerned about trends of years or more.
4) Concentrate on your exit timing. Investors in general tend to spend too much of their effort on figuring out what stocks to buy and when to buy them. They leave their exits to chance or just sell when they need to raise cash. They forget that it is the exit and not the entry that determines the outcome of an investment. Let me repeat that statement: “It is the exit and not the entry that determines the outcome
of an investment.” Please don’t forget that! Remember that Black Swan study we referenced?   If we want those big profits we have to know when to sell to avoid those big declines.
5) Don’t expect perfection. Even the world’s most successful investors make mistakes but these successful investors are quick to take their losses and move on.  Successful investors are also willing to sell a stock to reduce risk and then willing to buy it back even higher if the trend resumes. Don’t expect or attempt to buy at bottoms and sell at tops. Take it easy and just do your best to capture the easy parts of the obvious trends.
6) Do some homework. If you are looking for some suggested reading I would recommend Gerald Loeb’s classic book, The Battle for Investment Survival and Dr. Van Tharp’s more recent book, Trade Your Way to Financial Freedom. Of course, when it comes to exits I have to put in my plug for www.SmartStops.net.  It really is the best exit service bar none.
7) Always limit your risk and know how to calculate exactly how many shares to buy for each investment you make. A detailed webinar on this topic can be found on this blog in right hand column.   Controlling risk is a simple two-step process that this webinar will explain.

Believe it or not, you are now well on your way to being a successful investor and market timer. Good luck and remember to keep it simple!

 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 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.

Saudi Arabia is also selling more oil to that other Asian economic giant, India. Saudi crude exports to India grew sevenfold between 2000 and 2008. The desert kingdom now provides about a quarter of India’s oil.

Meanwhile, total demand for oil in the U.S. and Europe is flat at best.

The changing oil dynamics, however, is not a simple story. It’s getting more complicated.

Look at Saudi Arabia. It has its own rapidly growing economy and is consuming more of its own oil. The kingdom consumed 3.18 million barrels of oil per day in the third quarter of 2011. This is only a bit less than the 3.25 million barrels of oil per day used by India during the same time frame.

Bottom line…roughly a third of Saudi Arabia’s 9.8 million barrels of oil per day production last month was absorbed by domestic consumption. This means less and less oil is available to sell overseas.

Taken together with increased demand from Asia, it means higher prices for oil down the road for American consumers.

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

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

 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).