Volatility Expectations Continue To Wave Concerning Flags

EXPECTATIONS LIKE THIS ONLY ONE OTHER TIME

We have data for the Volatility Index going back to 1990. There has only been one other time in the last 30 years that had a VIX reading as high as the close on March 12, 2020. The rare VIX reading appeared on October 24, 2008, during the height of the financial crisis.

Was the market close to a bottom on October 24, 2008? Yes, an intermediate-term bottom. Was the market near the final bottom? No, not even close. The first set of charts below show a 14.71% snapback move that occurred after October 24, 2008; the rally ended on November 4, 2008. That turned out to be a bounce and it was all given back and then some. The S&P 500 eventually dropped 23.95% below the S&P 500 close on October 24, 2008 (point A).

HOW COULD THIS BE HELPFUL?

It helps us remain open to two important concepts: (1) typically, sharp multiple-day or multiple-week rallies occur from such lopsided market conditions and (2) volatility expectations say it is prudent to understand that much lower lows are still possible. We all know 2020 is unique and will follow a unique path.

What is the VIX saying? The reading on March 12, 2020 is saying 30-day expectations for stock market volatility have only been this high one other time. That one other time is not a warm and fuzzy period. To the contrary, having gone through the financial crisis in real time, I have often thought what a great experience it was to see maximum economic and systemic concerns. Typically, maximum concern levels are reached for serious fundamental reasons. The blurb below comes from Investopedia:

The Volatility Index, or VIX, is a real-time market index that represents the market's expectation of 30-day forward-looking volatility.

Typically (not always), a near maximum expectation for 30-day market volatility does not occur in a fundamental and technical environment that places high odds on making THE bottom. An intermediate-term bottom in the coming days and a powerful percentage gain would not be shocking. In the 2008 case:

• A sharp countertrend rally occurred within days.

• Much lower lows were still ahead.

• An excellent entry point surfaced after the next big leg down.

NO PREDICTIONS, NO FORECASTS

All outcomes are possible in 2020. Like the current reading on the VIX, price action over the past few sessions has a very concerning look and feel. As always, we will head into Friday’s session with an open mind about all outcomes. The market is near two common institutional guideposts: the S&P 500 200-week moving average and the 250-week moving average. A weekly close above the 200-week, which would require a green session Friday, would improve the odds of some intermediate-term stability.

MORE DETAIL IN THIS WEEKEND’S VIDEO

If Friday turns out to be another sharp decline, it might be helpful for clients to add up their exposure to cash/bonds/gold and compare it to their stock exposure. This ratio speaks to our exposure if the S&P 500 does indeed make a much lower low as it did in the 2008-09 case.

Entering The Exponential Growth Phase

THURSDAY: Game plan remains the same except the model is sitting near an inflection point which means we will be moving away at a faster rate if the market cannot show us something. We will be prepared at the open.

CASES COULD GROW RAPIDLY

We can expect to see a dramatic increase in the number of coronavirus cases in the United States in the coming days and weeks. For example, on January 25, 2020 there were only 2,000 reported cases in China; a month later that number had swelled to 77,700. Some experts project a significantly higher growth rate of cases in the United States due to the mobile nature of our democracy. Regardless of which end of the spectrum the United States falls, we should expect increasing concerns and complications over the coming weeks.

FASTEST PLUNGES FROM NEW HIGH IN HISTORY

Investors just experienced the fastest 10% correction in stock market history, which means after the stock market made a new all-time high on February 19, price action immediately moved into “never seen before” mode. Investors are now dealing with the fastest 18% drawdown in stock market history. Let’s assume you were prepared for the previous fastest 18% drawdown in history that occurred in 1929. The 18% drawdown in 1929 occurred over 28 trading sessions. If you were prepared for the “worst”, you would have overestimated the number of trading days to reallocate by 115%. Instead of the previous record of 28 sessions, the current 18% drawdown occurred in less than half the time or 13 sessions.

BALANCE BASED ON NUMEROUS FACTORS

While we have a mix of defensive-slanted assets (cash, bonds, gold, lower-volatility stocks), a prudent question might be why not just sell everything on the growth side of the portfolio. That is a fair question and if the market cannot show us something, we may be 100% out of the stock market very soon. The reasons we are not 100% out at this point are numerous, including: (1) the hard data has not deteriorated to that level as of this writing, (2) we are attempting to balance short-term concerns with intermediate-term probabilities, (3) bonds did not confirm Wednesday’s selloff, and (4) even the worst-of-the-worst bear markets have featured significant snapback or countertrend rallies after reaching oversold conditions.

Even in the context of longer-term bear markets, the table below shows snapback rallies or countertrend moves can be significant. If we are 100% out, we miss 100% of the countertrend move. Is it possible under current conditions and with the coronavirus coming to the U.S. that we will not see a typical snapback rally? Yes, hence the balanced approach. We have not and are not assuming a countertrend move is coming; we are simply respecting it is a possibility.

HOW MUCH LOWER COULD STOCKS GO?

Given the situation in Italy and the nature of trying to contain a virus, it is difficult to answer the question above with a high degree of confidence. However, we have seen several “the last time this happened or the only other time this happened was 2008” data points that can provide some guidance. The tweet below shows one example that could be helpful.

As noted above, the VIX has only reached recent levels one other time (October 2008). How much further did the S&P 500 fall before making the final low? The answer is 32.30% from the October 8, 2008 closing price to the intraday low on March 6, 2009. In the 2008-2009 case, the lowest low was not made for over five months. We will continue to take action if the market cannot prove something.

STAYING FOCUSED FOR FUTURE OPPORTUNITIES

The fastest 10% correction and fastest 18% drawdown can easily lead to frustration and a feeling of helplessness. That being said, we know the most successful people and leaders are able to compose themselves in difficult situations. The same concept applies to investing. It is important we respect the present-day risk while being able to see the other side of what could be a difficult period for many around the globe.

The best risk-reward opportunities in the world of investing present themselves during periods marked by serious fundamental issues. The U.S. stock market and economy have rebounded after depressions, world wars, oil embargos, and numerous crises over the past 120 years. What type of opportunity presented itself to those who did not give up and instead composed themselves and focused on the task at hand? As shown in the table below, the average gain was 84.78%. The table also helps us gain some historical perspective on how far markets have dropped in the past and the need for ongoing diligence.

IT SEEMS LIKE RARE DROPS ARE BECOMING COMMON

The market dropped like a stone in January 2018 and plunged in an extremely rare manner months later in Q4 2018. Now, we have more “the fastest” drops in history data. Is it possible technology, computers, and the speed of information flow has permanently altered what is normal in the stock market? Yes, it is possible and there are ways for us to take that into account walking forward by simply utilizing our existing tools in a different manner.

THE GOOD AND THE BAD

While it may seem like stocks have shown nothing since selling off on February 21st, the S&P 500 was able to recapture its 200-day moving average at the close on March 2nd. March 3rd also featured some nice gains following the Fed rate cut.

But since March 3rd, the facts have been slanted in a very concerning manner and the data has deteriorated significantly, something that is reflected in our allocation adjustments between the close on March 3rd and March 11th.

MORE TO COME AND THANK YOU TO CLIENTS

We are very fortunate to have the ability to work with an outstanding group of clients. We greatly appreciate the ability to stay focused on the primary task at hand during periods of volatility. We are all in this together and we care a great deal about ushering us to the other side in the weeks and months ahead.

STAY SAFE

Americans have a history of pulling together and helping each other in times of hardship. We are confident a similar spirit will be demonstrated over the coming weeks and months. We appreciate your support and will continue to take prudent steps in the days ahead. We hope all stay safe and healthy.

More information on markets and our approach will be available in this weekend’s video.

This post is for clients of Ciovacco Capital Management and describes our approach in generic terms. It is provided to assist clients with basic concepts, rather than specific strategies or levels. The same terms of use disclaimers used in our weekly videos apply to all Short Takes posts and tweets on the CCM Twitter Feed, including the text and images above.

Sunday Evening Weak Futures

For Clients:

The market is dealing with a big plunge in oil prices. From CNBC:

“Oil prices plunged 30% in early trading after OPEC’s failure to strike a deal with its allies regarding production cuts caused Saudi Arabia to slash its prices as it reportedly gets set to ramp up production, leading to fears of an all-out price war.”

Game plan will be the same as last Friday. Will see where we stand versus the data after the open Monday, and more importantly, where we stand near the close. Market can look significantly different at 9:30 am ET vs. 4:00 pm ET.

The S&P 500 closed Friday at 2,972. As noted in this weekend’s video, history says even if the market can find a bottom in the coming weeks, it would not be shocking for the S&P 500 to drop to 2,820-ish. To reach 2,820, the S&P 500 would have to drop 152 points on Monday. Our concerns would increase with an extended stay below 2,820.

Heading into Monday’s session, our allocation to cash, bonds, and gold account for the ongoing uncertainty. If the data calls for additional action, we will make the necessary adjustments. We are not making any assumptions about how Monday’s session will play out. More information about historical risk and reward from similar market profiles can be found in last Friday’s video.

Stock Market Performance After Rare Volatility Spikes

ADDITIONAL DRAWDOWNS/S&P 500 TABLES (1990-2020)