Saturday, May 9, 2009

Multiple Confirmations of VIX Model-Canary in a Coal Mine

Headknocker is mostly indisposed due to events involving the family.  But the Lord decided to wake me up at 5 o'clock this morning with yet another thunderstorm.  I was just grateful that it was not at 4 A.M.  Last night, I attended something called a rehearsal dinner at one of the better Italian restaurants in Nashville. As those who know me would expect, I looked on the menu for a cheeseburger and fries, and could not find that offering anywhere. LB did wonder why the event was called a "rehearsal" since there was no rehearsing. It must be what RBs call a rehearsal. RB chimed in and said that the nerd thankfully was never given an opportunity to put one of its name tags on the occasion.   

The Vix Asset Allocation Model is by far the most important subject in this blog. I personally view it as 100 times more important than the next most important line of discussion. So far at least, the Model provides the individual investor with an important tool to assist them in making stock asset allocation decisions.

The basic premise is that heightened levels of volatility indicate a substantial increase in the risk of stocks as an asset class.

The historical corollary of heightened risk is the increased potential of significant disruptive losses, potentially very disruptive to the needs and plans of the individual investor.  The model was tailored within a few minutes after first viewing a volatility chart for the S & P 500, called the VIX in 2007.

The first thing that a reader needs to know is that the model correctly predicted the current bear market before it happened, with a major Warning called a Trigger Event in August 2007, an extremely important and critical event that disrupted the bull pattern in the VIX in place since October 2003 in the S & P 500. Another trigger event happened in November 2007.

Trigger event is simply a descriptive term, meaning a Trigger in the allocation to stocks has just happened and I needed to adjust my exposure to stocks, not up but down. The converse is also true.

When the VIX moves down into a stable pattern of below 20, I would increase my exposure to stocks.  The model allows these moves into and out of stocks to be tailored to each individuals needs and tolerance level for risk. There is no fixed rule about what to do with a green light signal, or a flashing yellow or a red light with sirens blaring (i.e. a movement of the VIX into what I called Phase 2 of the Unstable Vix Pattern). The key is that heightened levels of volatility, particularly coming out of a stable pattern of below 20, is an important factor to consider in stock allocation decisions.  When the canaries start dropping dead in the coal mine, it is time to pay attention. "Canary in a Coal Mine"? 


The Vix can be like that canary.

One major confirmation of the Model after it was developed was applying it to a different index, the S & P 100, as it moved toward the crash of 1987. The Model flashed a Trigger Event in April 1987. More on the Vix Model: What it Does not Predict is as Important as What it Does/Parallels to VXO 1987-1988

The model on the RVX led me to substantially dispose of my small cap stocks in 2007 and the signal sent by that model was being confirmed by other indicators. Small Caps and RVX model

Oddly, every Trigger Event has been followed by an opportunity to lighten up at higher prices as the bull and bears fight it out.  The bears win during the Trigger Event period, as the market tumbles, but then the bulls fight back and manage to take the market averages back up before the "sh--" hits the fan.  LB always wants to emphasize that this opportunity is not part of the Model and may or may not happen again. It has just happened in the past.

The basic contours of the VIX model was also applied to other major indexes like the DJIA, Russell 2000 and the Nasdaq, that had their own separate volatility indexes.  The DJIA is considered the most stable of the indexes and LB is not surprised that it was the first to cross below 30 from the Cataclysmic Event levels of the Phase 2 pattern.

It most likely will be followed next by the VIX, and the volatility indexes for the Russell 2000 and Nasdaq will be the last too cross. Although the Model allows for adjustments based on the inherent volatility of the index (i.e. Nasdaq is more volatile than the DJIA), with the most important point on any of the charts being 20, the basic precept remains the same. A directional move to heightened levels of volatility from a stable pattern of below 20 is a Critical Event. And, movement below 20 will be correlated with a bull move in the index.

The most significant exception of a bull move at elevated levels was the 1999 parabolic moves in the averages which was never confirmed by the volatility indexes. In retrospect, the volatility indexes were correct about the move, they were phony. I would be more concerned about the Model now if the VIX was staying at heightened levels of 70, 60, 50 as the market rallied since early March. But, that has not happened. The VIX has been falling with the market averages which is consistent with what I would expect under the Model, a confirmation. So I view the model now as still valid.

My last point is that the movement back into stocks was flashed by the VIX staying below 20 for three months after coming out of the Unstable VIX Pattern.  This rule is flexible.  It worked coming out of the bear market at the beginning of the VIX data in 1990-1991 and in 2000-2002. The 3 month period was inserted by a cautious, conservative investor-LB- as a capital preservation tool, to avoid as much as humanly possible a false signal. This creates tension with other timing rules used here at HQ, one was discussed in a recent post, which led to the first significant shift out of cash into stocks in early March since the commencement of the bear market. More Of Less Safe After Averages Fall-Tension with Vix Model

I mentioned a story about my father suspending construction in 1973 in a post from yesterday. The words that I heard then were "Live to Fight Another Day", a common but apropos saying. August 2007 was a time when that saying needed to be heeded. This is a lesson that General Hood needed to heed in November 1864 at an event attended by at least one ancestor, the Battle of Franklin, which happened just a few mile from HQ. Second Battle of Franklin Hood's decision making process that day provides a valuable lesson for investors and business people: wait for a better opportunity, sometimes it is best to just walk away, and live to fight another day.  (the decision of Hood needed to be predicated on what he saw in front of him that day. The actions of a Union Brig. Gen. Jacob Cox, a temporary commander of the Union XXIII Corps, first to arrive at Franklin that day, was critical to the outcome)

And the importance of the model extends far beyond investors. Trigger Event : Cleanse Your Mind of Preconceptions, Dig Down Deep & Think Outside the Box

While LB is a formulator of Rules, it is not dogmatic and constantly challenging the reliability of its own rules, and will drop one of them in a heartbeat that ceases to be of use.  RB just said that someday LB's aging brain is going to get lost in those stinking rules.

Many of my posts about the VIX model can either be found during this month in the index to the right of the post or by links provided in those posts to discussions in prior months.   

This article is worth a read about how FASB 159 is helping the banks now to create earnings, in what is called a credit value adjustment related to the valuation of the bank's own debt.

I have no training in accounting and can only relate what other people say about this issue, previously discussed in a prior post. FASB Rule 159 and Bank Earnings/ Torture and the Imperial Presidency: Why are those Conservative Values?

Personally, I am not going to give the banks any credit for earnings tied to that kind of adjustment.  I will give a company like S L Green credit for an adjustment when it actually purchased and retired debt at a discount to par value, as opposed to pretending to do it. SL Green/Dysfunctional Pricing In KTN today/ GM Bondholders: Most Likely a No Deal on Common Stock for Bonds/

I did manage to raise a small amount of cash in a retirement account Friday by selling two securities with limit orders placed before leaving HQ. My intention is to use the proceeds to buy a synthetic floater.

Friday was one of my best days in the market since this bear started, possibly the best day if you exclude those one day wonders back in the 4th quarter of 2008. It is almost beyond my comprehension how well a large number  of my securities are doing now.    

It may be next week sometime before I have the time to transition to discuss specific stocks and earnings reports.

I did notice from the weekend WSJ that some TCs and floaters that I own go ex interest on 5/12 including the TCs JZE, JZJ, JZV with their semi-annual payments. The synthetic floaters can be identified on today's WSJ dividend page with names that start with terms like "Strats" or "Synthetic"

Also a reader can search topics in the blog by using the regular Google search service, the advanced option, and enter my blog address without "www" in "search within a site or domain"and then the key words that interest the reader. I entered VIX Asset Allocation and this is what turned up: site:tennesseeindependent.blogspot.com vix asset allocation - Google Search

There was a favorable article in Barron's about Campbell Soup. A Classic Soup Stock Looks Tasty - Barrons.com

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