Monday, October 10, 2011

The Perils of Predicting Equity Market Moves

Last Thursday I published this post discussing US equity market levels and volatility. Among other observations, I wrote,

"Now, on any given day, the S&P can easily close in territory that moves the signal to 'short' for next month. Specifically, if the S&P return for this month is much worse than -2%, the signal will go 'out/short.'

Thus, I moved the bulk of my funds which were in equities into cash yesterday. Because the signal wasn't 100% solid, but only an intra-day low, I didn't move 100% of the assets.

For what it's worth, more than a few pundits and fund managers appearing on CNBC and Bloomberg have said they are doing the same in the past week.

For perspective, I took a look at the S&P levels and volatility since then. Beginning with that first Greek crisis in the markets, the S&P was at roughly 1110 to 1130. My proprietary options volatility signal rose to 'put' levels by early April, and stayed there for the next six months.

In the intervening months, the S&P has climbed as high as 1363 on 29 April 2011. Now it's back to where it was, more or less, at the start of the Greek crisis last year. Holding long equity portfolios generated by my proprietary strategy in the interim would have allowed an investor to realize gains for most of that period. Gains which would be rebalanced as portfolios rolled on and off. A sort of slightly more sophisticated variant of dollar-averaging, if you will.

But now, volatilities, and, thus, risk, in both my proprietary options and equities signaling systems have risen to critical levels amidst equity market levels which aren't providing concomitant returns.

As I write this post at about 1PM on Wednesday afternoon, the day before it will publish, the S&P is at 1131. A slight gain from yesterday. But in times like these, any one day's equity market performance isn't the point. It's the overall trend, or lack of one, coupled with instantaneous and recent volatility that guides my quantitative long/short signals. The qualitative economic and financial information I process provides context.

And now, the context and the signals are flashing to be mostly out of US equities."
The S&P finished Wednesday at 1144, then 1165 the next day, when the post was actually published. Today, Monday, at 1:50PM, it's at 1189.

Yes, making public statements about the direction of equity markets surely can be painful- at least in the short term. Or longer, I suppose, if you're Byron Wien and predicted an equity market collapse for about, what, three straight years? Until finally, like a broken watch, his prediction coincided with reality?

However, volatility is actually greater today than it was last Wednesday, when I wrote that post. The S& closed at 1210 three weeks ago. Meaning that the movement in the index continues to be violent. The pattern of the S&P daily closes, resembles, graphically, a distinctive saw-toothed pattern of generally range-bound values with rapid, sharp changes vertically over the past three months. Thus the abrupt rise in volatility at the beginning of August which has continued, only moderately abated.

Today's rally is based upon investors' hearing that Germany's and France's leaders claim to have a plan to resolve the European debt crisis. On Friday morning, US equities were up on what some believed were good jobless numbers. So why did the S&P close down -.8% that day?

What will happen in a few days, when the Euro-bears like Kyle Bass reiterate their fairly sensible, sane observations that there isn't enough money in the European Union to rescue all of the endangered sovereign credit, now including downgraded Spain and Italy? That there will be defaults and corresponding declining economic activity which will have effects on the US economy? I wrote in that post,

"Bass discussed how ludicrous it is to expect some nations, like Spain and Italy, to be guarantors of bad Greek debt today, then turn around and become receivers of further Euro help tomorrow. Bass referred, again, to his firm's original market research among Germans regarding their attitudes toward bailing out the rest of Europe, and added, this time, a reference to private conversations with senior German government officials. This smacks of the legwork Bass was known for, ex post, in the 2007-2008 mortgage crisis, as displayed on Faber's House of Cards documentary."

While CNBC, Bloomberg and the Wall Street Journal all strive to make an entertaining, must-watch or -read day out of every day the equity markets are open for trading, the truth is that to an equity portfolio manager of other people's money, such daily moves don't affect most of the portfolio. In my case, my call that it's time to be out of US equities won't really be clearly right or wrong for at least another month. Back in 2008, my equity signal was triggered in mid-summer. The equity market cratered first, rapidly, in October, with Lehman's bankruptcy, then again in March of the next year. The signal didn't recommend re-entry until after that.

So for the meanwhile, I'll continue to monitor S&P daily closes and associated volatility. It's not clear to me yet that it's safe to remain fully invested in equities. A month's S&P gains can be made up by a portfolio manager with a consistently superior-performing strategy. But a month's losses of, say, 7% is quite different. In the former case, the assets are still there, and the S&P has a slight incremental lead. In the latter case, it's likely that more than 7% of your assets are gone in one month, meaning you must earn the losses back from a smaller base.

Thus the asymmetrical risk, if you wish to call it that, of sitting out a positive S&P month amidst excessive turbulence, versus actually losing money as the market disintegrates, when your signaling system warned you to be cautious as the equity market neared a precipice.

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