So far, January 2022 has not been kind to the markets. At one point during the day Monday, the S&P 500 was off by more than -11% after putting in an all-time high at the start the year. The markets have certainly seen an increase in volatility. Volatility is a sign of confusion and fear, which is a bearish characteristic.  

We have been very vocal about the risk in the markets due to its sector weightings being out of balance. It is important to keep in mind that the S&P 500 and many other market indexes are not balanced portfolios. The S&P 500 is a capitalization-weighted index, and therefore is momentum-based. In other words, the best performers over an extended period become the largest components. If those components, which in this case are more growth-oriented, experience volatility, the general market will also experience an increase in volatility.

A series of outlier days

Of the 15 trading days in 2022, 10 of the days have been down, and half of those have been down by more than -1%. The volatility of the S&P 500 has gone from a low point of CVI 48 (Canterbury Volatility Index) to CVI 88. Rising volatility is a negative characteristic and equates to rising risk in the markets. The CVI Volatility number is less important than the velocity of the increase. As of now, the S&P 500’s CVI has increased about 60% since mid-November. That is a substantial increase.

Monday, Monday (Bah-da bah-da-da-da). Can’t trust that day.

At one point during the trading day on Monday the 24, the S&P 500 was off by a little more than -3.8%, and at one point, 94% of stocks were down during the day. 

With the S&P 500 off by -5.68% last week and 4 consecutive down days of -1% or more, one probably wouldn’t assume that the market had much further to go before seeing a kickback. The market volatility on Monday probably stemmed from a lot of negative investor psychology.

After seeing the volatility of last week, investors had time to let the market’s drawdown and negative emotion brew over the weekend. We are all aware that the longer a person bottles-up negative emotions, the larger the eventual outburst or reaction. In terms of the markets, many investors sold into the open and throughout mid-day, releasing the bottled-up stress from last week’s movement. Now, it’s impossible to consistently predict the long-term market direction, but history tells us to expect to see a kickback or small rally in the markets. Once investors reach the point where they throw in the towel, we tend to see the selling dry up followed by an opposite (short term reaction), some of which we saw late Monday as the S&P 500, which had previously been down -3.8%, finishing slightly up for the day.

Portfolio management

Reading about the markets and the rotation in the relative strength among the sectors means nothing without an action plan to benefit from it, particularly when dealing with volatile markets. 

From Canterbury’s perspective, our Portfolio Thermostat was positioned for volatility in the markets. While bonds have done very little to offset market risks in the last few months, there had been defensive tools available. One tactic utilized by the Thermostat strategy was to own 3 inverse positions to stabilize portfolio fluctuations. Inverse positions move in the opposite direction of their underlying asset. So, if you have an “inverse Russell 2000” and the Russell 2000 is down -1%, the inverse would be up +1%. These positions, coupled with the rotation to value sectors, have helped limit the volatility in the portfolio. 

We saw the S&P 500 fall by more than -10% (through Monday’s intraday low), which is considered to be a normal bull market correction. The big downside here is that it fell by -10% on high, increasing volatility, all in one direction, and in a matter of a few days instead of weeks. If there is one thing we know from several studies, it’s that volatility goes both ways. Even the worst bear markets have seen some of the largest up-days and rallies. We are not in a bear market yet, but are beginning to see some key characteristics, such as volatility, come to forefront. So, what is the strategy from this point?

The recent move in the markets has occurred very fast. Sharp, quick drops like the one the market is experiencing usually precede sharp, quick rallies. It’s like the stretching of a rubber band—it’s only a matter of time before the drop is extended and snaps back to some degree.

To adjust for this, you need a strategy that can adjust its exposure to the markets, like the Portfolio Thermostat. In other words, the Thermostat has been positioned correctly heading into this volatile move. It can now rotate to adjust for a potential kickback, and then continue to make adjustments as the market fluctuates in both directions. 

Bottom line

This has already been a lengthy update, so I will put the Bottom Line into some key bullet points:

  • The markets are volatile, and the volatility has been primarily led by the market’s largest components, which had previously led the markets
  • Monday saw a lot of volatility as investors capitulated based on their negative emotion coming out of the weekend. The markets rallied off of lows substantially late in the day
  • Volatility goes both ways. Outside of Monday’s late rally off of its intraday lows, all of the volatility has been to the downside. Volatile markets will experience large outliers in both directions. This market is no different. I would expect to see some large up-days to go with large down days
  • Volatile markets require a strategy for dealing with the varying fluctuations. The Portfolio Thermostat was built to deal with volatile markets. We were well-positioned as we headed into the recent turmoil and will continue to make adjustments as we navigate the volatility in the market

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Source: Nasdaq


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