Tuesday, April 7, 2009

VIX Signal is At Best a Timing Indicator for Cyclical Bear and Bull Markets

ADDED 5/13/2009:  For some reason, many new readers interested in this topic are being sent to this post which assumes a great deal of familiarity with my VIX Asset Allocation Model.  I have a Gateway Post that collects most of my major posts on this subject:USING THE VIX MODEL AS A TIMING INDICATOR FOR LONGER TERM STOCK ALLOCATIONS
If you are interested in this topic and want to see a chart of the VIX and a discussion of the Alerts and Triggers given in 2007 before the start of this bear market, I would recommend reading these posts next, with the first linked post below explaining the model, and the second one applying the model to the VIX chart in 2007:

***************************************ORIGINAL POST

I do not believe that my VIX signal will tell me whether I am in a long term secular bull or bear market.  So far, historically, it would successfully signal an entry into, or out of stocks.  It is more of cyclical bull/bear signal, meaning short term dominant trends that may last a couple of years, possibly 3 or maybe 4 at the outside.   It clearly, for example, gave a bull signal in February 2004 and a bear signal in late 2007. Trading and Asset Allocation in Stable and Unstable VIX Pattern   However, in my view, both of those signals occurred in an ongoing secular bear market, that is defined by me as one lasting more than a decade of flat end to end movement.  We have basically flatlined back to 1996-1997 as of March 2009. 

 Similar cyclical bull and bear  signals have been given by this indicator in the past.  BEEPRA VIX LXPPRD/ More on VIX AND ASSET ALLOCATION 

Classifying the trend as a long term bull or bear market is more difficult and problematic.  For a couple of years during this decade, it looked like a new bull market had started, particularly in 2005 and 2006, at least before the mortgage problems started to appear in the headlines almost daily which commenced in February 2007.   What suggested that this move was not the beginning of a long term bull market?   There is some historical evidence that a new secular bull market needs time to form out of the depths of a long term secular bear market.  While the final end of the 1982 secular bull in 2000-2001 was painful, a longer recovery period would be necessary to rid the system of all forms of speculative excess, including illusory growth financed by excessive and risky leverage, which was not accomplished after the popping of the stock bubble at the start of the decade.  Now, all of the bubbles created by the conditions fostered by the prior long term secular bull market have been popped with the last one, the improvident creation and extension of credit, being the most important, severe and problematic of all of the prior bubbles.  Once the process of de-leveraging is completed, and prices for stocks reach levels enticing to long term investors, then the foundation of a new, long lasting bull market in stocks can be formed, and I suspect that we are almost there now.  

Looking back at the last four years of W's term, and the rise of the stock market to October 2007, the growth experienced was phony, a debt created mirage, a house of cards, that could not be sustained.  So even though the market was rising, the rot was apparent to anyone who looked or thought about it.  Growth based on a reckless expansion of debt has no lasting foundation, so the bull move between 2003 to 2007 was a cyclical bull market in what is now a clearly defined long term secular bear market as I have defined it earlier in this post and elsewhere.    

I can really get into a good disagreement marking the start of the secular bull market that ended in 1965.  I start it in 1949 at around DJIA 167 and ending in October 1965 at around 969. The moves after 1929 and prior to 1949 I characterize as bull and bear cyclical moves occurring in a long term secular bear market.  Some of the best bull percentage moves occurred during that period but that does not translate into a bull market in my book. By 1949, after all of that up and down movement, the DJIA was still below where it was before October 1929. 

Now, what does all of this have to do with asset allocation.  I did substantially pare my stock exposure in 2007 due to my concerns which were developing  throughout 2007 about the credit expansion as well as the signals being sent by my newly developed VIX indicator which was being confirmed by all other indicators that I was using at that time.  So that was my first response-sell stock and raise cash.  My second response was to learn a lot about bonds and to start buying them.   A different and more finely tuned strategy will need to be developed for the future, once I characterize the market as being in a long term secular bear market.  A long term secular bull market is easier, just increase my exposure to stocks. I will simply have to do a better job in the future of  identifying which asset classes will increase in value during a very long period where stocks are flat, and there may only be a few categories of such investments, mostly in the bond asset class other than high yield bonds.  Treasury bonds have worked during this bear market, but may not work in the next down cycle, possibly some other instrument will be the choice for safety, some income and a return of principal.  Stocks as an asset class will need to go down in percentage terms as part of the asset allocation, possibly increasing during a cyclical bull and decreasing back to normal allocation for a secular bear which would be much lower than currently recommended by most financial advisers.   But this larger issue, what to do in a secular bear market, is still a work in progress, and hopefully I am learning a lot from the one that I am currently living through so I will be better able to deal with the next one better, though I would give myself a B+ for navigating this one since 1999.  

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