An example of one of my elegant models blowing up happened in September 2008. The model that blew up was a trading model based on the VIX Asset Allocation model. The trading model was then called the SSO/SDS Swing Trade (SSO=Double Long ETF for the S & P 500; SDS=Double Short for the S & P 500). The first experimentation of trades based on the movement of the VIX were primitive. If the VIX went up during the Unstable Pattern, I would sell SDS into it, and then buy it back when the market averages rallied and SDS in turn would cooperate and fall in price. Then, it occurred to me, just watching the chart, that I would do better with the trade by holding off on the buy of SDS during the Unstable Vix Pattern until the VIX fell to below 20, then I changed that to below 18 to increase my profit. That last change caused me to miss buying SDS back in August 2008 (LB was trying to be too smart, to make a few extra bucks on the trade by waiting). Whatever, I also saw that it would then be best to sell SDS once the VIX shot back to 30 or over, and the market would cooperate for that trade by going down a lot. The pattern was obvious up to the end of September 2008: S & P rallies, VIX falls; S & P falls, VIX rallies and SDS is supposed to go up twice whatever the S & P goes down and SSO goes up twice whatever the S & P 500 goes up. So, voila, the swing trade was born. The problem is that I did not have any data about the VIX bursting out of the what I now call the Phase 1 pattern of the Unstable VIX Pattern, meaning a Whipsaw Pattern between 20 to 30 with some spurts over 30 and below 20, a pattern inconsistent with a longer term, investable bull market in stocks. When that pattern burst in late September, I did manage to react some by selling stocks. Volatility, Catastrophic Event Formation, Asset Allocation Decision for Pepsi September 2008 I had a deer in the headlights look on what to do with my Swing Trade so I just moved on after the Vix blew up the Swing Trade model by skyrocketing to unprecedented levels.
There were two days of below 40 in the VIX after the formation of the Phase 2 pattern, before the storm hit with full force. It would not be long before the Category 5 hurricane would be on top of you. Those days were 9/30/08 and 10/01/08. I am going to use Yahoo's price for SDS adjusted for subsequent dividends. On 9/30/08, it closed at 61.08. By October 27th, SDS was at 99.29, so there was a meaningful opportunity to hedge after the Phase 2 formation, but no luxury for thought was provided. It had to be done quickly or not at all. LB and RB were just dumbfounded that one of their elegant models just got blown up and consequently did nothing, even though something needed to be done and both the egghead and the animal spirit knew it.
The Lehman failure would be an example of an outlier event occurring that has the effect of blowing up the best laid plans of a human modeling machine. I knew that the Swing Trade Trading Model, as it then existed had been blown up when the VIX blew through 40 by moving in one day from 34.74 to 46.72. Now what?
Now, after reflecting on what to do when a Phase 2 Unstable Vix Pattern starts to form, my only meaningful contribution is to suggest that I will take the first opportunity to put on a long term hedge and to keep it on until there is a decisive break in the Phase 2 Unstable Vix Pattern, i.e., a move back below 30 showing some stability, possibly removing half after a fall to the 40 range from a spike to over 50. LB will later try to figure out how to trade the hedge so it becomes profitable in addition to providing insurance, something that it has yet to shown that it can do with any consistency. LB has proven to the satisfaction of staff that it was able to trade the hedges successfully prior to the onset of the Phase 2 Unstable Vix Pattern.
Some of my prior discussions on the Swing Trade can be found at:
(I see in that post that I said that I did not think that I had the VIX Model in May but by mid summer of 2007. My first trade on SDS was pursuant to the seat of my pants model, basically I do not remember now whether it was May or June 2007 which is an irrelevant point anyway)
(this later post does hypothetical Swing Trades during the 2001-2002 bear market, which was a test of the Model)
I also did a hypothetical test for the 1990s. BEEPRA VIX LXPPRD/ More on VIX AND ASSET ALLOCATION
Other discussions of the Swing Trade and the Blowup of the then existing model:
What is important now is what I am able to learn from this experience for application in the next bear market. So I am thinking about that now.
The VIX Asset Allocation Model, ex Swing Trade, is still in force and viewed as a reliable signal here at HQ. Everyone else can make up their own mind about it. This Model is still a work in progress, but most of the newer stuff is just to make it more pretty and less rough.
Now on to a new topic, in this stream of consciousness approach to writing, no way to know what comes next. I do not even know.
I mentioned in a prior post that International Government bonds were a non-correlated asset. Intel/International Bonds as a Non-Correlated Asset By that I mean that I am not likely to know what that asset class is doing by looking at the S & P 500 or even international stocks. It could easily be going in the opposite direction to stocks. I read a post that listed the ETF for International Government bonds, BWX, as producing a 4.44% positive return in 2008. Yahoo! FinanceThat would be a low correlation with what happened to stocks around the world last year. I have read remarks by some who advise a U.S. investor to avoid buying International bonds since there are two ways to lose, through a fall in foreign currencies versus the U.S. dollar and a rise in bond yields caused by inflation or other factors. Of course, the opposite is also true. There are two ways to make money. Although I have not done a precise calculation, I know that I have made money in the international bond asset category. And what caused most of my gain? It was due to the fall in the dollar versus other major currencies like the Euro and the Japanese Yen that juiced the dollar return to me. To me, this indicates that this asset has an enhanced risk to it for a U.S. investor, and with enhanced risk comes opportunity.
I sold my international bond mutual funds, making a good profit on the shares in addition to the dividend in either 2007 or early 2008, after the dollar had fallen in value against major currencies named above as well as the Australian and Canadian dollars. A few months thereafter, I bought and then sold BWX, with my first successful trade in that ETF, prior to starting this blog. After the dollar started a bull move, the value of BWX fell even though it was buoyed some by having a lot of low yielding Japanese Government bonds in it, which were then appreciating in value for a U.S. investor based on the strength of the Yen versus the dollar. There is a currency ETF for the Yen, FXY, which I have never owned, preferring to play the Canadian and Australian Dollar currency ETFs, with occasional forays into the Brazilian Reel and the Swiss Franc currency ETFs. I digress.
So when the currency movement started to knock BWX down below 50, I came back to BWX as a stabilizer in my asset allocation, and built up a position. BOND ETFS BWX AND TFI I also added WIP.
So for me, I am comfortable managing risk for securities with enhanced risk characteristics, and consequently I am not scared or bothered by the additional layer of risk associated with international bonds for the U.S. investor caused by currency fluctuations. I want those fluctuations. I do no want to invest in a fund that tries to hedge it away which just costs me money and may prove to be a negative anyway. I just view international bonds as just another asset in need of risk management, and as a non-correlated asset in my asset allocation.
I will check later tonight to find a name or two from prominent practitioners of asset allocation arguing against international bond positions due to the currency risk. I understand that point, and will just ignore it. I believe David Swenson is one of them. As I said, I will do it my way. My positions in WIP and BWX would be foreign government bonds which lessens the credit risk.
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