Corrections Corporation Mention in Barrons/Small Caps and RVX model

There was a discussion of Corrections Corporation in Investor's Soapbox published online at Barron's on 12/31/08.  Barrons.comThe stock was being recommended by Avondale Partners for some of the same reasons discussed by me in a prior post. ADD of Corrections Corp of America (CXW) with cash flow Two other stocks were recommended by Avondale, and I am already familiar with one of them, Psychiatric Solutions (PSYS).  I was not aware of the other America Service Group (ASGR) which is a micro-cap. I will just place it on my monitor list.

My RVX model, based on the volatility of the Russell 2000, caused me to exit my individual small cap positions in 2007. In retrospect, and I have discussed this already, it would have been best to take the position to zero. I made the mistake of keeping a good sized position in two closed end funds that invest in small and micro cap issues, RVT and RMT, based on a few considerations. .   

First, I knew that I might be wrong about what my RVX model was telling me in 2007, and the RMT and RVT positions would be a way to participate in this sector in case I made a mistake in jettisoning my individual small cap positions.  

Second, both of those closed end funds operated by Royce, a well known and successful mutual fund family devoted to these small and micro cap stocks, paid very generous dividends that I would reinvest in additional shares which I am still doing.  So, I reasoned that, even if I was right about a bear market forming for small caps, the reinvestment of the sizable dividends paid by those two funds would be a way to average down in a bear market.  That is what I am doing now with these two funds but it was not the best way to proceed.  In retrospect, I was actually buying the double short TWM and I had sold my individual selections. I was negative, very negative on this sector. I should have sold out of RVT and RMT too, and waited at least a year to start building the position back up. 

This is some of my commentary on the RVX model that was sent out in an email as modified to reflect developments up to mid 2008 which is the last revision that I made in this commentary, so you need to keep in mind that the comments do not reflect any developments since about June 2008 (I will revise it some more in the 1st quarter of 2009 to reflect trading patterns since 6/08):

"This Chart has to be interpreted differently from the VIX, but the underlying principals of the analysis are the same for both VIX AND RVX.

The RVX does show a bull pattern in the 15 to 20 range between October 2006 and the end of February 2007.  On February 26, 2007, the RVX traded between 15.18 to 16.18. The next day was a decisive one for this chart. The range expanded from 17.32 to 23.34, with the size of that trading range significant, and the RVX closed near its high at 22.05. The chart also shows a break in the line with a small space between February 26^th and 27^th.  

All of these factors combined, meaning the decisive break of the bull pattern from a close of 15.81 to the next day close at 22.05, the size of the range of trades on the 27^th, and the gap in the line chart, establish a very clear warning of the approaching end of a bull market for small caps.

This is a five-year chart of the Ishares ETF for the Russell 2000, IWM.  This chart reveals a bull market in small cap stocks from 2003 until mid 2007, marked by higher highs and lower lows.  The IWM hit a high of 84.11 on 10/10/2007, which was very near its prior top of 85.74 on 7/9/2007, which has significance of course with my prior discussion of the VIX. Some technicians would call this pattern a double top and would call the end of the IWM bull market based on that indicator, possibly others, which is confirmed by my reading of the RVX.

 Starting in early June 2007, the RVX was starting to show stress.  The readings would rise into the low 20s and fall back to the 19 to 20 level, back and forth. By June 25^th, the fall back to below 20 was over and the range would be in the low 20s everyday. Then on July 20^th, there was a volatile day with a low of 20.64, a high of 23.07, and a close at 22.63 or greater than a 10% fluctuation intra-day.  The next day was telling.  There was another gap in the line chart, with another 10% move to a high of 25.92 and a close at 24.72.  By mid august the readings were hitting the mid 30s. with several days having readings above 30 for the entire day. 

The IWM was still moving in a bull market pattern as late as mid July 2007, closing at over 85 on July 17^th.  If it was owned what was the RVX saying to do?  Soon after hitting this top, the IWM slid into a 10% or so correction to the low to mid 70s with bursts to close around 80.  On September 18th it made a second attempt to reach a new high and closed at 81.61 with an intra-day low of 77.26 and proceeded to extend its rally to October 11^th when it hit an intra-day high of 84.89 but closed off the high at 83.16. After failing to make a new high, and forming a double top formation, it rolled over and started its current range bound whipsaw pattern of trades mostly in the mid-60s to mid-70s. At a close of 72.32, it is near the high of its recent trading range. Recent intra-day highs would be around 75 since the choppy pattern started after the gap fall, waterfall, in early January 2008.  

So we know that the IWM chart itself provided clues of the bear market for the Russell 2000 that could not be ignored by January 2008, when the bull chart pattern was unequivocally broken.  

But what if you did not have any chart but the RVX and you owned IWM. What would you know if all you had in the universe was the RVX chart and no other information.  

First, I would see immediately that the Russell 2000 is a riskier index than the S & P 500. The sheer amount of movement tells me that this index will be more volatile, and hence involve more risk than the larger stock index of more established companies. Unlike the VIX chart, there are few readings below 15 and no steady pattern below 15 in the RVX as shown for extended periods for the VIX.  Moreover, the period in the 15 to 20 range is much shorter than the VIX.  When the bull pattern is broken, there are clearly defined gaps in the chart in both February and July 2007. When the unstable RVX started in a way that could not be dismissed in July 2007, it went to higher elevations than the VIX with no readings since then, unlike the VIX, below 20.  You will also see more readings in the mid-30s with the RVX than the VIX. All of these factors lead me to conclude that a trading strategy for the Russell 2000 has to be tailored to that index and cannot be copied from a VIX strategy.

With any index considered more risky and volatile, the first thought needs to be preservation of capital.  So at a minimum, the RVX gave a profound warning to reduce your small cap position in February 2007 with a spike in a few days from a bull pattern of 15 to almost 25. This would mean a 25% reduction in one’s small cap position whenever the RVX returned to 16 to 20, either all at once or in stages.  I am creating a broader range to trigger the reduction, as well as the size of the reduction, for the Russell 2000 compared to the S & P 500 based on the look of the charts for RVX and VIX  .............

The RVX chart starts on May 8, 2006 in a bull pattern with trades between 16.47 to 17.73 with a close at 17.37.  So we do not have data before that date when the IWM was undoubtedly in a bull market.  I can only guess what it would show.  I would say a bull pattern mostly in the 15 to 20 range with spurts into the low twenties. But I do not know. I do see a warning given by the RVX soon after the chart starts.  By mid May 2006, the  RVX makes a clear break over twenty. 

By June 12^th, the RVX closes at 32.63 and at 28.44 on July 21^st 2006. This could not be ignored. For the time frame shown, this would be the first warning.  Other warnings may have preceded it but we cannot know the answer to that query.  We can only say that if you owned small cap stocks in June 2006, a year before the first VIX warning for the S & P 500, there would have to be a forced reduction of  25% of the small cap portfolio whenever the RVX returned to 16 to 20.             

The above chart shows when the first reduction of 25% could be made in small cap stocks. It also shows that the RVX could bring you back in prematurely to small caps with a three- month bull pattern, which the VIX bull pattern has not yet done.  Since small caps are proven to be more risky and more unstable comparing the RVX with VIX, the stable bull pattern has to be extended to five months before reallocating capital to small caps after raising capital from forced model reductions from the three-month trigger for the S & P 500. So we have already made some important changes in the allocation model for the Russell 2000 index and small cap stocks in general.....

To summarize, the reductions will occur in two stages of 25% each when the RVX returns to 16 to 20 and that cash will remain in cash until a stable bull pattern in the 15 to 20 range (allowing of minor and temporary breaks above 20 on a closing basis to account for the more volatile nature of RVX compared to VIX) FOR FIVE MONTHS. "

I would estimate that I eliminated about 80% before the end of 2007 with the other 20% in the small cap category being in the funds.  So I did more than suggested by the model. I am not a slave to these models and use them only as one of many trading guidances. I am not using it entirely now because I started to re-enter some narrowly defined small cap sectors notwithstanding the current level of RVX. 

Everything needs to modified with each passing day with flexibility always being a key ingredient along with non-rigid approaches always subject to change by an intelligent evaluation of new information.    

Most of the discussion and all of the charts have been omitted from this post. 

DISCLAIMER:

  I am not a financial advisor but an individual investor trying to navigate my way through a difficult market. In these posts, I am acting as an unpaid financial journalist and an occasional political commentator.   I am also aggregating financial news stories that I view as important and providing any reader of these posts, assuming there are more than a couple, with links to those articles, sort of a filtered, somewhat intelligent, free search engine.  Any discussion made by me of particular securities  is not a recommendation to buy or to sell.  Trade at your own risk.  Consult with your financial advisor prior to making any purchase or sale. I will try to identify my sales too but it may take a few minutes after I implement them to create a post explaining my reasons.  The sale may before or after the post.  Before buying or selling any stock, even one recommended by a trusted financial advisor,  please research it and make up your own mind which is what I always try to do.  Research would include reading reports, reviewing financial records, earnings estimates, sec filings and prior earnings releases and news.  In this post, and all others by me, I am merely describing my reasons for purchasing  or selling securities, and the potential pitfalls that I identified prior to purchase or the reasons for a sale.  The securities mentioned in this and all posts written by me may not be suitable for others based on their unique financial position and risk profile.  Always read the prospectus before buying a Trust Certificate, bond, preferred stock or other bond or bond like investments.  Information contained in my posts has been obtained from sources believed to be reliable but cannot be guaranteed.  These posts by me do not constitute investment advice, nor shall they be construed as a guarantee of future results, or as an offer of any transaction in securities.   All content in these posts is provided for informational and entertainment purposes only, and are certainly a form of entertainment for me.