#$vxn

Market Is Processing New Information

Last Thursday, the S&P 500 closed at 2,133. Following an above expectations GDP report on Friday, October 28, the S&P 500 rallied 8 points. Shortly after 1:00 pm, with stocks green for the session, the Clinton/FBI story broke.

The market quickly dropped 21 points turning an 8-point gain intraday into a 13-point intraday loss. As of the close on Wednesday, November 2, the S&P 500 is 43 points below the pre-Clinton news high.

Market Is Operating As It Always Does

Given the sharp drop since the story broke, it is reasonable to surmise the market was pricing-in a Clinton victory. Therefore, every chart we reviewed prior to the moment the FBI news hit the wire was based on what is now dated information and dated assumptions. This concept is not new; it is how markets function. Markets make short, intermediate, and long-term forecasts based on the information in hand. When new information comes to light, markets (and charts) adjust their forecasts as needed.

Allocation Strategy

Given the concept of markets/charts adjusting to new information is standard operating procedure, our approach does not need to be altered to deal with what is now a more uncertain outcome in the U.S. presidential election. If the markets sell-off sharply before the end of this week, we will make the necessary adjustments, just as we would at the end of any other week.

Thus, prior to election day, our task is to remain allocated in line with the evidence we have in hand. On Monday evening, the evidence may be worse than what we have today, about the same, or it may be better. If the market does not like the outcome of the election, we will adjust as needed and at a rate in line with the rate of change in the evidence. If the market likes the outcome on November 8, we will adjust as needed and at a rate in line with the rate of change in the evidence.

Binary Events

Since the election could be a binary market event followed by significant gains or significant losses, it is extremely important we are ready to respond to any form of new information (favorable or unfavorable). It is important to note, the market does not care about our personal view of either candidate or our opinion about what the election outcome will mean. The net aggregate opinion of all market participants determines the value of our investments.

If the market thinks something is relevant, it is relevant. If the market thinks something is irrelevant, it is irrelevant. Thus far, the market is telling us it believes the narrowing gap between the two major presidential candidates is relevant.

Current Allocation In Line

As noted earlier this week, the market’s intermediate-term profile falls into the “needs to be watched closely” category. We will continue to check our portfolio’s risk-reward profile relative to the facts we have in hand. Thus far, we remain in line with the facts; something that is subject to change in the coming days.

Perspective is easily lost if all you do is watch one slice of the market. The whole picture can alert you to a lot. Not just when to be concerned, but also when to look for opportunities.

If you focused solely on the Russell 2000 small cap index, the following picture probably sums up your experience and expectation. 

If all you've followed are large caps then the image below is probably your view, comparatively speaking. 

In case you haven't looked at either market this last year take a gander below. The S&P 500 ETF (left) and Russell 2000 ETF (right) are polar opposites. 

Back to perspective. One way I look at the whole market is by examining implied volatility. This gives a sense of fear by directly measuring expectations of those with money on the line.

Specifically, I combine all of the volatility indexes for the major US equity indexes, creating a composite of volatility/fear for the entire US Market. I can compare that composite VIX to the Wilshire Total Market Index, which measures the performance of all U.S. equity securities with readily available price data. 

So what does this fear composite look like? In the chart below, the Wilshire is in the top pane while the VIX composite is below.

Peaks in the VIX composite mostly match to bottoms in the Wilshire. Having a good estimate of what level volatility/fear is likely to have run its course would be very useful. I wrote an algo that does just that. You can read more about specifics here. 

The last real-time peak in fear, shown with red arrows, was detected on 10/10 and 10/13. Other peaks were detected in late-January and mid-April. Results of this approach on the VIX can be seen here. 

So what can we infer from this study? For starters, I would look for a peak if the VIX composite neared 120. This is the level that the algo would tag as a likely extreme. That would translate into a likely bottom in the market, being around the corner.

Can a bottom in the market happen without volatility reaching 120? Absolutely. Can volatility reach 120 and continue higher? Absolutely. Unexpected/underestimated world events, black swans and those other pesky unknown unknowns keep us on our toes. That said, the odds of a peak in volatility occurring if volatility reached that level and the market being higher 1 year later are 68%.

Just as useful, though, would be volatility settling back down below 67. Volatility remaining over that number would imply that traders are still expecting elevated levels of chop to continue.

Today's ChOTD continues what has become a redundant theme of "low volatility" charts. We'd like to say this will be the last volatility-related post, but it probably won't be. The nature of low-volatility environments is that they lull investors to sleep -- then, boom! It is the same with reporting on the topic. After awhile, it kind of gets monotonous. However, we'd recommend investors steel themselves from being anesthetized to the present low volatility conditions because they truly are historic. Today's low-vol example is the Nasdaq 100 Volatility Index, $VXN.

A week ago, our 5/12 ChOTD illustrated the Nasdaq Composite's relative increase in volatility vs. the NYSE, as measured by the "average true range" of the indices. Today's ChOTD provides more evidence of the increase in volatility among that higher-risk segment of the market. The chart shows the ratio between the Nasdaq Volatility Index (VXN) vs. that of the S&P 500 (VIX).

As shown, the VXN:VIX ratio recently jumped by over 40% in a 3-month period. Since 1999, this has proven to be a warning sign for the broad market, albeit advance warning at times. The ratio spiked to that level in late 1999/early 2000, spring 2001, early-mid 2006 and October 2007. Each of these spikes preceded serious damage to the market although the market continued higher for another year+ following the 2006 readings.