Sunday, August 8, 2010

Current Status of The Vix Asset Allocation Model Signal

1. Current Status of the Vix Asset Allocation Model Signal: The last major signal given by my Vix Asset Allocation Model was to reduce stock exposure after the Trigger Event in August 2007. VIX Chart from 2007: Alerts and Triggers Major Disruption of Cyclical Stable Bull VIX Pattern A Trigger Event occurs when the VIX shoots out a long-standing Stable Vix Pattern of continuous movement below 20 by rising close to 30, and then remaining at elevated levels for several days.Vix Asset Allocation Model Explained Simply The Trigger Event marks the formation of an Unstable Vix Pattern, a far more dangerous market for an individual investor, particularly those facing significant situational risk. The Trigger Event is by far the most important signal given by the model, and one that can not be ignored.

The U.S. stock market has been in an Unstable VIX Pattern since August 2007. To end this pattern, I will require 3 movements of movement below 20, possibly allowing for a brief move into the low 20s without restarting the count. Earlier in 2010, the VIX was moving in a continuous pattern below 20 for several weeks before the European sovereign debt crisis caused the VIX to quickly move back into the 30s. ^VIX: Historical Prices for VOLATILITY S&P 500 That disruption is not a Trigger Event but is simply a reconfirmation of the Unstable Vix Pattern. Other problems contributed to the resumption of instability, including data indicating a slowdown in U.S. growth and a continuation of stagnation in hiring.

After receiving a big jolt starting in early May which took the VIX briefly over 40, the VIX has been gradually returning toward the important 20 demarcation line again. This is a characteristic of the Phase 1 of the Unstable Vix Pattern, a period marked by rallies and declines, sound and fury, with the end result being stagnant or negative returns over a long period of time particularly after adjusting for inflation.

The Unstable Vix Pattern will likely be anathema to the buy and hold stock investor. It is a trader's market, and an extremely difficult one to trade. One of the major dangers for the trader is being caught long when a Phase 2 Unstable Vix Pattern forms. Generally speaking, the Trigger Event will cause me to substantially reduce my stock exposure and to enter into a trading phase. Possibly some long term positions will be added during this phase, but mostly I am in a trading mode. One tenet of the trading mode is to sell on pops and buy on the dips, and part of that activity can be timed by the movement in the VIX. During the Unstable Vix Pattern, Phase 1, the VIX will be in a whipsaw pattern moving mostly between 20 to 30, as now, with fairly brief spurts above 30 and below 20. The movement below 20 would be a signal to lighten up some and then to add back positions on a pop to the low or mid-30s. Trading and Asset Allocation in Stable and Unstable VIX Pattern More on VIX AND ASSET ALLOCATION The problem comes when the movement into the 30s explodes into a huge spike into the 40s and beyond. That could catch the trader long and cause severe pain. My response is just to reverse the recent buys when I see a Phase 2, Unstable Vix Pattern form, as I did in September 2008 but nowhere near enough. SEPTEMBER 2008: FORMATION OF THE DEADLY PHASE 2 OF THE UNSTABLE VIX PATTERN While there was a couple of days in September 2008 to make that change before the crap hit the fan in a big way, there is no guarantee that any warning will be given before there is a collapse in prices characteristic of a Phase 2, Unstable Vix Pattern (also called the catastrophic phase of a long term bear market in this blog; every long term secular bear will have at least one catastrophic phase that will give long term investors with strong hands and stronger stomachs excellent entry points).

Prior to the VIX data, there was volatility data on the S & P 100 which had a Trigger Event before the 1987 crash. Parallels to VXO 1987-1988 There was no warning (^VXO: Historical Prices) , however, of a formation of the Phase 2 pattern before the October crash. The VXO went from 36.37 on 10/16/1987 to 150.19 on 10/19 and 140 on 10/20. So the model would have saved an investor money by reducing stock exposure after the Trigger Event in 1987 but would have caught the traders in the crash unless something else had spooked them to reduce positions.

I thought that it would be helpful to copy how I break the time periods into patterns since the CBOE started to publish VIX data in 1990:

"3. Historical Time Periods for Unstable and Stable Vix Patterns and S & P Movement Within Each Pattern:

In numerous posts I have discussed the importance of identifying whether the U.S. stock market is in an Unstable or Stable Vix Pattern for purposes of providing some guidance about asset allocation and trading strategy decisions.{ See, e.g. More on Failures of Standard Asset Allocation Models and Target Funds/Use of Volatility in an Asset Class to Make Adjustments to an Asset Allocation Trading and Asset Allocation in Stable and Unstable VIX Pattern The Roller Coaster Ride of the Long Term Secular Bear Market }

The following synopsis assumes familiarity with the broad contours of the VIX Asset Allocation Model as outlined in Vix Asset Allocation Model Explained Simply With as Few Words as Possible. The application of the model to an asset allocation decision in 2007, which mandated a reduction of stock exposure in August 2007 after a Trigger Event, a major disruption in a Stable Vix Pattern, is outlined in VIX Chart from 2007: Alerts and Triggers Major Disruption of Cyclical Stable Bull VIX Pattern.

Some other important posts that discuss the importance of these events in asset allocation and trading strategies include the following:

In the following Table, I am defining the periods of the Unstable and Stable Vix Patterns since the onset of the VIX data in 1990. At the start of the Vix data series in 1990, the stock market is in a cyclical bear market within a long term secular bull market starting in August 1982. I am marking the end of an Unstable Vix Pattern by continuous movement below 20 in the VIX for 3 months, allowing for some minor and short term movement above 20. Before making an asset allocation change after the start of the Unstable Vix Pattern, I wait for the return of the VIX to below 20 after the Trigger Event. This has worked since 1990 but may not in the future. It permits the investor to sell at a better price after the Trigger Event, which is invariably associated with a decline in stock prices.

Stable VIX Pattern: March 1991 to October 1997
Week Ending 6/12/1991 S & P 500 382 ^GSPC ^VIX
End of Stable Pattern October 1997-Early Nov 1997: ^VIX
Wait for Return Below 20 in the VIX-W/E 2/9/1998 S & P 500 1012^GSPC ^VIX

Unstable VIX Pattern October 1997 to October 2003
Start of Unstable Pattern: S & P 500 at 1012 (Measured not from Trigger but return of Vix to less than 20)
End of Unstable Pattern: S & P 500 at 1050 ^GSPC ^VIX

Stable VIX Pattern October 2003 to August 2007
Start of Stable Vix Pattern: S& P 500 at 1050
Return of VIX below 20 After END of Stable Vix Pattern in 8/2007: S & P 500 at 1525 (9/17/2007) ^VIX: ^GSPC

Unstable Vix Pattern August 2007 to Present
Return of Vix to Below 20 after Start of Unstable Vix Pattern: S & P 500 at 1525

Currently: S & P 500 Closed Friday 7/2/2010 at 1022.58. (as of last Friday, August 6, 2010: 1121.64)

I date the start of the long term secular bear market in October 1997 and one reason is shown in the foregoing. The start of an Unstable Vix Pattern in October 1997 is coupled with a return in the S & P 500 back to the level that the model said to sell in February 1998. Even during an Unstable VIX Pattern, there can be profound up cycles which could be profitable for those who are lucky enough to play the move. However, the lesson from the Vix's history is that the market will end an Unstable Vix Pattern period at or below the starting point, usually after a number of years. Before the onset of the current Unstable VIX Pattern, the prior one lasted SIX YEARS. I suspect, more of a guess, that the start of the next Stable VIX Pattern will start below S & P 1525, possibly around S & P 1250, possibly in 2 or 3 years, near the mid-point of the last Stable VIX Pattern move."

No comments:

Post a Comment