Outlier Day in the Market
We have been saying for the past few weeks that the markets could experience an “outlier day.” As a reminder, Canterbury defines an “outlier day” as a day beyond 1.5%, up or down. As of Friday’s close, the Canterbury Volatility Index read CVI 48 on the S&P 500. This volatility level is extremely low. In other words, the market had been lulled to sleep. When this occurs, there is a higher probability of one of these outlier days occurring, just like the day experienced Monday, September 20th.
The outlier day of -1.70% (-2.80% was the low) on the S&P 500 was enough to signal a “volatility spike,” moving market’s environment from “bullish” to “transitional-bullish.” Most of the time, a spike in volatility coming from an extreme-low volatility level will go back to a normal bullish market environment. It is similar to a sleeping person getting hit with a cold glass of water: they awake startled and takes them a few moments to assess their surroundings. The market just got hit with a cold glass of water and will take some time to assess where it wants to go next. Canterbury monitors volatility changes daily.
Broad Market Strength
We have alluded to the markets being shaky across the board. In fact, large caps have taken on the burden of caring the markets higher the last 5 months, while small caps and mid-caps have moved sideways.
The Russell 3000 is a market index composed of the largest 2,900+ US securities. While its composition of nearly 3,000 US securities far exceeds the 505 stocks that represent the S&P 500, the Russell 3000 is still market cap weighted, meaning those large caps stocks that have led the markets have a larger impact on the index’s movements.
The following statistics were provided by Carter Worth, via “Cornerstone Macro: Money in Motion—September 20th, 2021”
- The Russell 3000 represents 98% of the U.S. equity markets.
- The market capitalization of the index totals $50 Trillion.
- The index is trading at about its 150-Day Moving Average and is continuing to rise.
- While the index is above its 150-Day Moving Average, nearly 57% of the index’s components are below their respective moving averages
- As of Friday’s close, the Russell 3000 was 2.4% below its 52-week (trailing 1 year) high, “and yet [95.1% of the stocks within the index] are down more than 2.4% from their respective highs.”
Now, being off by 2.4% from a high is nothing to be concerned about. What is concerning is how top-heavy some indexes are composed. The Russell 3000 index is performing better than 95% of its holdings. That would signal that a select few stocks are carrying that market, which is reflective of what we have been discussing in previous updates concerning the advance-decline line. In other words, the strength of the broad markets is being overstated by large-cap securities.
Portfolio Management
The Canterbury Portfolio Thermostat is an adaptive portfolio strategy. An adaptive portfolio is one that moves in concert with changing market environments, as opposed to always holding a fixed asset allocation and diversification. For the past several months, the markets have been in a low-volatility bull market state. Because of this, the Canterbury Portfolio Thermostat has reflected that bullish equity environment and holds several equity exchange-traded-funds.
Given Monday’s outlier event, we want to highlight some of the adjustments that were made in the portfolio prior to Monday. Just because the S&P 500 is in a bull market environment, does not mean that every equity index is also in a bullish market environment. To decrease portfolio volatility, and increase the portfolio’s “benefit of diversification,” the Portfolio Thermostat has exposure to both inverse China and inverse Emerging Markets, two equity indexes that are experiencing higher volatility. These inverse positions are supposed to provide portfolio defense in the event of a change in market environment. In the case of an outlier day, like the one seen on Monday, the inverse positions limited the portfolio’s fluctuations, even though it is situated for a bull market environment.
Bottom Line
It is easy to question why markets do what they do. Why has the market gone up for the last few months given all the negative news that has been out there? There will be several news headlines discussing why the markets went down on Monday. One such headline on Market Watch reads: “Dow slides 2% as implosion of China’s Evergrande rattles stock market.” We encourage investors to disregard the headlines and the “why” to the markets. The “why” is not important. What is important is the reality.
It is reality that the market had a higher probability of experiencing an outlier day due to the extreme low level of volatility recently. Typically, these sorts of days result in the market returning to normal behavior. We cannot say that with certainty, but we have done several studies that show that there is a higher probability of returning to a normal market environment.
On the other hand, a spike in volatility can shake investor confidence. Volatility spikes reflect confusion and can be the match that lights the fuse to set off more outlier days. The Portfolio Thermostat had already anticipated the potential for a market pullback, or correction. The Thermostat’s system had “buy” signals on the two inverse ETFs mentioned in this update, as well some other “more defensive” sectors like consumer staples, commodities, and real estate.