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. Read More…
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
Chicken or Egg? Risk Tolerance as a Driver of Financial Success
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.
If you can’t beat them join them, Best Buy. BBY
by Chris Georgopoulos, SmartStops contributor
Reading financial articles can be, let’s say boring at times. This article we are going to try to spice it up, let’s play a game of role playing. Famed speculator, Jesse Livermore once was quoted…
“If I were walking down a railroad track and saw an express train coming at me at 60 miles an hours. I would be a damned fool not to get off the track and let the train go by. After it had passed, I could always get back on the track, if I desired.” –Reminiscences of a Stock Operator, Edwin Lefevre.
For this game let’s rename the train, Best Buy stock (BBY: NYSE), the ““I” in walking down the track” we can call the shareholders of Best Buy and the speed of the train, the issues. The game is scored by the costs of each decision. Whoever has the best return wins!
It is the end of summer 2005, Best Buy is approaching $80/share and the future couldn’t be brighter. The tech bubble burst is ancient history, the housing market is hot, interest rates are low and every house in America is an ATM for consumer spending. You are on the railroad track…there isn’t a train in sight!
It is now the beginning of fall 2008; Best Buy has fallen to the mid $40s in defiance of the market making new highs and there are rumors of problems in Mortgage backed securities. (Note: Sidestepping risk is now made possible with the release of SmartStops.net which if had been available would have had you out in the $70 range in 2005). Your friend has made a fortune flipping speculative properties in south Florida and Las Vegas, but you see he is worried. He still has five houses on the market with almost no personal income… (You know how this story ends) You can hear a train coming and it sounds like it’s really moving!
Only a few months later, Best Buy is trading under $18/share! The rumors are true; the housing market has crushed the stock market. It seems nobody thought housing prices would ever go down and the economy is on the verge of total failure. You can now see the train, its moving fast and finally you start to consider if you should actually get off the tracks.
(SmartStops.net issued two Long-Term exit signals in 2008 the first January 4, 2008 at $46.80 and on September 16, 2008 at $40.68. That’s a $22 per share savings by sidestepping risk.)
It is two years later; Best Buy is trading back in the mid $40s. Read More…
Rethinking Modern Portfolio Theory
Are we all doing it wrong — or is the theory in need of updating and repair?
I think MPT died 30 years ago,” says Jeffrey Saut, chief investment strategist at Raymond James. “If the theory were correct, Warren Buffett, Peter Lynch and Paul Tudor Jones wouldn’t have their track records.” He says that although 60% of Lynch’s trades resulted in losses, he could manage downside risk precisely because he wasn’t tied to a strategic asset allocation. “Asset allocation-and just about any other model-works in a bull market,” Saut scoffs. “But the driver of returns in a bear or range-bound market is stock selection and risk management.”
So far, no other single method has knocked the Modern Portfolio Theory off its perch as a coherent way of structuring portfolios and pricing assets. But more and more practitioners believe the theory doesn’t deal adequately with today’s world.
Poor Harry Markowitz. Every time investors get whipped in the financial markets, they take it out on his Modern Portfolio Theory (MPT).
Investors don’t kick Markowitz only when they’re down. MPT also came under gleeful attack during the technology boom of the late 1990s, when “risk” was a dirty word. What sense does it make to diversify out of an asset class that’s returning 30%? Plenty, of course-but try telling clients to keep a little money in cash during a raging bull market.
Why does MPT look so good on paper, yet fail so spectacularly every few years?
Know when to Hold ‘em, Know when to Fold ‘em
SmartStops comment: Its why this service was brought to fruition. Follow SmartStops and you can be protected before you lose it all.
Unprecedented Monthly Volume Sell-Off Suggests Now’s the Time to Take Shelter - published at Minyanville by Kevin A. Tuttle
Do not concern yourself if the market goes up today, tomorrow, or a month from now. The risk of entering is not worth the reward.
Over the weekend I had the pleasure of speaking with a very prominent European money manager – overseeing hundreds of billions – about the “across-the-pond” financial crisis unwind and looming hazard of a potential domino-effect coming to fruition. Without rehashing the entire conversation, the consensus is not “if,” it’s “when” will the developing pressure finally blow. He actually went so far as to say it could truly begin unraveling within the next few weeks considering the catalysts currently in play.
The intent of providing the conversation synopsis is not for sake of fear, but understanding the potential ramifications. About three years ago, in one of my firm’s quarterly reports, we opined on a unique situation in regard to the GDP measurements of Global Nations. It stated the unprecedented growth statistics from the 56 nations tracked. “History is currently being made in the sense that all the globally tracked economic growth nations (56), every one… 100%…, are showing expansion.” This lead to my next comment… “If the economic cycle pendulum swings in both directions what would happen if the inverse occurred?” Are 2011/2012 the years we are about to find out? Maybe that’s somewhat extreme, but yet… is it possible?
We at my firm do not pretend to be intelligent enough to figure out all the nuances, catalysts, causes and reasons why the markets could fall apart; we’ll leave it to the team of economists and officials to attempt to sort that out. What we do instead is try to determine when the storm is coming and how to take shelter, which brings me to my point: Now is the time. Take shelter! Do not concern yourself if the market goes up today, tomorrow or a month from now. Clarity is key! Would you sail your boat into rocky waters with a potential hurricane looming because of your love of sailing? Is the risk worth the reward? For some, maybe; but for most, probably not.
S&P 500 Index
Since the “2011 Channel of Indecision” broke on August 4, the seas have picked up dramatically and have begun swallowing ships. The markets have never seen this type of monthly volume sell-off – 47% above average (unprecedented), as seen in the monthly chart above. As Kenny Rogers put it so eloquently… “Know when to hold em’ and know when to fold em’, know when to walk away, know when to run!”
Are ETFs Responsible for Rising Market Correlations?
SmartStops commentary: Diversification alone is not going to be enough to manage risk in our 21st century markets. Smartstops offers a superior dynamic intelligent risk management service. Ask yourself, who is watching your back?
originally published at ETFTrends
S&P 500 stocks are moving as a herd and the increased presence of exchange traded funds in financial markets may be partly responsible for the spike in correlations, according to a report Monday.
Stocks in the S&P 500 over the past month have a correlation of 80%, higher than the peak reached during the financial crisis in late 2008, The Wall Street Journal reported.
“One potential reason is the popularity of exchange traded funds. ETFs account for more than 30% of volume in U.S. stock markets, compared with just 2% in 2000,” the newspaper said. “It’s reasonable to expect ETF trading to drive correlation higher because many of the vehicles are tied to stock indexes.”
The three-month stock correlation in the S&P 500 is the highest in at least the past 20 years, while sector correlation is also elevated, according to a recent note from Goldman Sachs analysts.
A higher correlation means prices are moving together, rather than going their separate ways. [Sector ETF Correlations at Two-Year High: Strategist]
Correlations have spiked recently amid the so-called risk-on and risk-off trades. High correlations are not indicative of a healthy or normal market, analysts say. [Rising Correlations]
“Elevated correlation is generally considered a poor environment for long-only fundamental investors,” Goldman Sachs said.
401k holders – made out worse
SmartStops comment: Its disappointing to see that Fidelity puts out these kinds of stories, because god forbid, people would actually sidestep periods of great risk in markets. Sure – if you pick the time period from Oct.2008-March 31,2009, you’ll show a bad record vs. buy & hold. But why does the mutual fund industry insist on hiding the other part of that data that has been published – about how missing the worst days of the market can increase your returns by an amazing amount? And it means you don’t even have to be that good at timing when to get back in. Fidelity – have you seen these studies? In Defense of Market Timing
We wish SmartStops could have been ready by Oct. 2007 for the public to use, given that’s when our risk alerts started and you could have been out of the market well before the Oct. 2008 drop. In fact, you could have been bottom fishing all you wanted during 2008 (keeping your losses to a minimum with smartstops) to earn a much better return than the 2% Fidelity says people who held from Oct. 08-March ’09 earned. Yes, buy & hold can show the better performance numbers overall for any given time slice period, but what was the opportunity cost to you? If you could have been out of the market 50% of the time earning money with that investment vs. losing money, why would you think buy&hold was the better way to go? Think about that opportunity cost when you are looking at our performance comparison tool.
401(k) holders who bailed on stocks in 2008 made out worse: Fidelity
Remember that this is standard rhetoric from the mutual fund industry. They want your money just sitting there.
