By Brandon Bischof, Canterbury Investment Management
Market State 6 (Transitional): The S&P 500 is now in a Transitional Market State 6, following Monday’s spike in volatility. The Transitional Market State is a result of what is called a “velocity of volatility spike” (more on that below). The majority of Transitional Market States revert back to bullish environments. The process of going from Bull to Bear does not happen all at once.
Watch Now: Canterbury Weekly Update 2.24.2020
Canterbury Volatility Index (CVI)- CVI 71: The change to a Transitional Market State 6 comes from a “velocity of volatility” spike. Canterbury defines such a spike as at least a 7-point jump in the Canterbury Volatility Index. Monday’s outlier day caused a spike in volatility which meets that criteria. The commentary below goes into further detail on the history of velocity of volatility spikes.
When large outlier days occur, it is important to keep in mind that markets do not go from a bull market, to a bear market overnight. A transition from a bull to a bear requires a process. The S&P 500 peaked on February 19th. Including Monday’s large outlier, the S&P 500 is still only (-4.74%) off that peak. Canterbury defines a “normal” bull market pullback as one of about 5% from peak value, and a correction as 10-12%. The market is still in the realm of normal market noise.
Additionally, Monday’s market outlier caused a “velocity of volatility” spike, as defined above in the “Canterbury Volatility Index” section of the update. Since 1950, there have been 51 velocity of volatility spikes that led to a change from a bullish Market State to a transitional Market State. Of these 51 spikes, 80% (40 velocity of volatility spikes) went back to being in a Bullish market environment.
Monday’s (-3.35%) move, which comes out of a low volatility bullish Market State, was the 9th largest outlier day to cause a velocity of volatility spike. Remember, each velocity of volatility spike automatically triggers a shift to a Transitional Market State. The table below shows the top 20 largest outlier days to cause a velocity of volatility spike, along with the next market environment after the temporary transitional market environment, the maximum drawdown from the previous market peak, and the days it took to get to surpass the old market high prior to the spike. The data used is S&P 500 stock market data, dating back to 1950.
Note: the trading anomaly that occurred in December of 2018 was just a quick, sharp drop that eventually put in a new high only 135 days later (about 6 months).
|Date||Day that the velocity of volatility spike occurred|
|Outlier Day||The single day outlier that caused the spike|
|Next Environment After Transitional Market||Each velocity of volatility spike triggers a shift to a transitional Market State. This column shows the market environment that occurred after the transitional environment|
|Maximum Drawdown||The maximum overall decline from the previous market peak|
|Days to New High Following Spike||Following the velocity of volatility spike, how many days did it take to surpass the previous market peak?|
As you can see in the table above, of the top 20 velocity of volatility spikes, excluding Monday’s spike, all but one period reverted to a bullish market environment. The one period that did not was the trading anomaly that occurred back in December of 2018. Each of the spikes that reverted to a bullish market environment had total maximum drawdowns within a normal bull market correction of about 10%, and actually saw new relative market highs within 3 months or shorter.
The Canterbury Portfolio Thermostat does not aim to compete against any individual index or blended benchmark. We know that portfolio efficiency is a moving target, and all asset classes will go in and out of favor. The Portfolio Thermostat is an Adaptive Portfolio Strategy designed to navigate various markets and create an efficient portfolio for today’s environment- Bull or Bear.
Canterbury benchmarks its portfolio against key “internal” metrics, in order to measure portfolio efficiency. These metrics are Portfolio State, Portfolio Volatility, and Portfolio Benefit of Diversification. Together, these internal benchmarks create the Portfolio Efficiency Score.
The Portfolio Thermostat remains efficient for today’s Transitional Market Environment, which was caused by the spike in volatility. The Portfolio Thermostat is a total portfolio strategy, diversified among several asset classes. Even after Monday’s drop, the Portfolio Thermostat is still less than -3% off of its old high.
The Thermostat had low volatility and an efficient level of diversification heading into Monday’s volatility spike. As markets continue to go through various environments, the Portfolio Thermostat will continue to adapt and change to remain efficient.
This volatility spike is not a reason to panic. The market is still well within the range of normal noise. Pullbacks and normal fluctuations can be expected during bull market environments, especially if we have not seen one for quite some time.
Most transitional environments caused by a velocity of volatility spike go back to a bullish Market State. This is because going from a bull market to a bear market requires a process and does not happen overnight. Canterbury will continue to monitor for increases in volatility.
As we navigate this Transitional environment, the Portfolio Thermostat will make the necessary adjustments to maintain efficiency by keeping low volatility and a sufficient benefit of diversification.