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posted on 18 July 2017

Volatility Cycles

Written by , Clarity Financial

The smell of “fear" was quickly eviscerated with Yellen’s testimony last week as volatility plunged back towards historically low levels. As shown in the chart below, the recent “back and forth" action which had reduced the overbought condition of the market short-term, was quickly reversed on Thursday and Friday. Furthermore, the high-level of complacency confirms a move higher from current levels could well be limited in terms of magnitude.


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This abnormally low level of volatility continues to baffle market participants. The lack of “fear," should be worrisome for investors, instead, it has almost become a “badge of honor." I am just waiting for someone to print up a T-shirt that says:

“I survived the low-vol market of 2017 and lived to tell about it."

There is one thing, as investors that we should be keenly aware of. Like everything in life, volatility runs in very large cycles. This is clearly shown in the chart below.

There are two takeaways from the chart above. The first is volatility is at the lowest levels since 1990. The second is we are likely on the cusp of a long-term trend change in the trend of volatility. That trend change will likely occur with the onset of the next mean reverting event in the financial markets. (Note: the chart above is monthly, so it is very slow moving.)

This is very important.

It doesn’t matter if you THINK you are diversified. As my partner, Michael Lebowitz, noted previously:

“The truth of the matter is that blind diversification does not work simply because it does not take into account the effects of volatility on asset prices. Chris Cole from Artemis Capital, one of the clearest thinkers on the importance of volatility as an asset class, highlights this point in the following graphic."

720global-diversify-091316

“Contrasting the perception of a well-diversified portfolio with the reality of embedded volatility, the graph reflects enormous concentration risk in short volatility. Importantly, this risk matters most at the exact point in time when one expects - hopes - their strategy of diversification will protect them. Unfortunately, the well-diversified portfolio (left side) turns into the short volatility-concentrated portfolio in periods of extreme market disruption. Mr. Cole’s analysis may be best summarized with the popular statement that correlations on many assets go to one during a crisis."

Let’s put it this way. If you didn’t like what happened to your portfolio during the draw downs in 2016, just imagine what you will be feeling when a correction of some magnitude eventually occurs.

It is at this point when individuals stare into the ‘abyss,’ the realization of the ‘risk’ they have undertaken becomes most apparent. It is also when the mantra of ‘I bought it for the dividend’ changes to religion as the prayers are lofted for a ‘bounce to get out.'"

This is why I focus on risk and the inherent management of it. The returns will take care of themselves.


Confused?

This is a potentially confusing point for investors. How could we be talking about “risk" on one-hand, but looking for “opportunity" on the other? Good question. Let me explain.

Investors always make some fairly common mistakes in their portfolio management:

  • They buy something without a target to sell (target gain or stop loss).
  • They assume if they sell something they can never buy it again.
  • If they sell something at a loss, it is now forbidden fruit.
  • If they sell something at a gain, and it goes higher, they jump back in.
  • By not selling a loser they don’t have to admit they were wrong.
  • By not taking gains in winners, it confirms their “genius," until it reverses to a loss.
  • Etc., so forth, and so on.

These are all emotionally driven responses. Most bad habits of investors, individuals and professionals, revolve around their “ego." This is particularly the case of professionals who ostensibly believe they are “smarter they the average bear."

As a portfolio manager my job is actually very simple: Avoid major draw downs.

By doing just this one thing, you can literally outperform the market over the long-term.

  • NO…you will not beat the market from one year to the next which is a stupid goal anyway.
  • NO…you will not sell at the peaks and buy at the bottoms.
  • NO…you will not have regular appearances on CNBC.
  • YES…you will achieve your long-term goals.

The current market environment is NOT conducive to an overweight allocation to equity risk long-term. As I stated above, the risk-reward ratio is simply no longer in your favor.

By managing portfolio risk I can reduce the impact of the one thing that hurts long-term performance the most - losing capital.

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