1Q2019 Review: Market Volatility ETF

Bucking the trend of the fourth quarter of 2018, the US stock market has had a solid first quarter in 2019 – the best performance since 1998.
Cumberland Advisors - Quarterly Review - Market Volatility ETF
Our quantitative strategy produced multiple entry signals between late October and Christmas Eve. An exit signal occurred near the end of February and the first entry group went to cash. As readers have learned in the past, our quantitative strategy utilizes a binary model that either fully invests each separate account or stays in an all-cash position. The cash position allows us to buy when the market dips. We can also adopt leverage as a choice for less-risk-averse investors.
Our bullish view of the equity market built from the end of the fourth quarter last year and expanded into the first quarter in 2019. We continued adding to our positions during the sell-off and held those  positions throughout the volatility of the past four months. Although our model decided to exit one entry group near the end of February, we want to clarify that we were not making a market top call. Each of our exit decisions is carefully calculated through our mathematical optimization process. Rather than calling the top, the model targets the optimal exit point, where we will not miss the next dip to re-enter.  This quarter marks the three-year anniversary of the strategy.
Our quantitative model currently remains neutral. We are waiting for the next buy signal to reinvest the cash position, or, exit signal for the remaining 2018 entry groups.



4Q 2018 Review: Market Volatility

From the trade war to the Fed, the fourth quarter of 2018 has been full of uncertainty, which is markets’ least favorite scenario.

 

Market Commentary - Cumberland Advisors - 4Q 2018 Review Market Volatility

The US equity market posted one of the worst October numbers since the financial crisis. The NASDAQ tumbled 9% in October, marking its worst monthly drop since November 2008. Although the equity market caught some breath in November, the resumed sell-off in December has made the odds of a Santa Claus rally slim to none, especially if we take account of the possibility that some year-end tax-loss-related repositions may be exacerbating the market sell-off.

While a 10% correction in the market is not uncommon, there is one interesting aspect of the fourth-quarter market: intraday volatility. Out of 54 trading sessions so far in the current quarter, the Dow has had 16 sessions with intraday 500+ point swings since October 1.* This is roughly 2% of the current level of the Dow. We even had two sessions with 900+ point swings, October 10 and October 29. Additionally, the Dow had five consecutive sessions with 500+ point swings from December 4 to December 11. Not only does the market find it hard to establish some momentum in a rebound rally in this environment of unusually high intraday volatility, but market participants also tend to build bearish sentiment as the volatility drags on. For example, the latest AAII Investor Sentiment Survey, on December 13, showed the lowest bull-bear spread since February 11, 2016, even though the YTD 2018 S&P 500 return was basically flat then.

Our quantitative strategy started this quarter with all-cash position and went back into the market throughout the sell-off. We are currently invested and will hold a neutral position in the near future.

Have a great holiday.

Leo Chen, Ph.D.
Portfolio Manager & Quantitative Strategist
Email | Bio


*Data from Bloomberg, ending on December 17, 2018


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Leveraged ETFs

Our quantitative strategy at Cumberland Advisors is a trading model that combines fundamental indicators and quantitative analysis into a binary output – either fully invested or all in cash. The strategy trades the S&P 500 in two versions: unleveraged and leveraged. Specifically, the leveraged portfolio uses a leveraged ETF as our vehicle to track 3X the market movement. As many may wonder whether one should use a leveraged ETF, we would like to express our opinions on leveraged ETFs today.

Market Commentary - Cumberland Advisors - Leveraged ETFs

First, what is a leveraged ETF? It is simply an ETF using derivatives and debt to track and amplify the return of an index. However, a leveraged ETF does not expose investors to traditional margin risk; rather, investors just pay the ETF cost. A leveraged ETF resets each day and targets to track an index’s daily movement. A leveraged ETF is usually considered a trading tool. It is typically held for less than a week at most, and oftentimes just daily. Investors are generally told not to buy and hold this type of security due to “time decay,” a term that is often misused when applied to leveraged ETFs. Time decay is a term used to describe the loss of value of an option as time approaches the expiration date. However, leveraged ETFs are not subject to option expirations. What “time decay” really refers to, in connection with leveraged ETFs, is the compounding effect. For example, if the market went up 10% on day 1 and went down 10% on day 2, one would lose 1% at the end of day 2; with 3X leverage, one would go up 30% on day 1 and down 30% on day 2, being left with a 9% loss at the end:

1 – (1+0.1) x (1-0.1) = 0.01     (1)
1 – (1+0.3) x (1-0.3) = 0.09     (2)

Time has nothing to do with the math above. It is compounding that magnifies the leveraged number. In other words, anything that increased 30% and then decreased 30% would have the same outcome regardless of leverage. Imagine that equation (2) represented a scenario where the market went up 30% on day 1 and down 30% on day 2 – one would be left with 9% loss without any leverage or so-called “time decay” effect. Another example: If the market dropped 1% a day for 10 consecutive days, one would suffer a 9.56% loss, while the loss would be 26.26% with 3X leverage:

1 – (1-0.01)10 ≈ 0.0956     (3)
1 – (1-0.03)10 ≈ 0.2626     (4)

Again, the math demonstrates that time is not the reason for the significant difference; compounded return is the master behind the scene. To understand the power of compounding, let’s take a look at a famous motivational poster that some people have as their desktop – if you improve just 1% a day, you will be much better in a year:

Chart 1. 1% a day difference
Now that we have clarified the mathematical misconception, let’s dig into the more important question: Should one buy and hold leveraged ETFs? The chart below compares the 3X leveraged ETF SPXL against the benchmark S&P 500.

Chart 2. S&P 500 vs. SPXL, 11/5/2008–11/9/2018. Data source: Bloomberg

Clearly, the 3X ETF has substantially outperformed the S&P 500 since its inception on November 5, 2008. However, not every investor would have had the stomach for the volatility that was experienced along the way. Leverage can be a powerful tool to take advantage of a bull market if used properly, but one must possess extensive risk management skills. At Cumberland Advisors, we prioritize risk control by keeping our focus on risk-adjusted returns.

If you are interested in obtaining information about our quantitative strategy, please email me.

Leo Chen, Ph.D.
Portfolio Manager & Quantitative Strategist
Email | Bio


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VIX Inversion

VIX, the “fear gauge,” measures S&P 500 near-term volatility by using options that expire in 23–37 days. Therefore, the VIX we often discuss is the 1-month volatility index. However, the Chicago Board Options Exchange (CBOE) also publishes 3-month (VIX3M) and 6-month (VIX6M) volatility indexes, which are less well known.

Market Commentary - Cumberland Advisors - VIX Inversion

The 3-month and 6-month VIX indexes are usually higher than the 1-month VIX. Similarly, those VIX futures with various expirations tracking short- and long-term VIX movements also remain in contango most of the time. The reason is that the uncertainty inherent in the long term requires a risk premium compared to the short term, comparable to the term premium in fixed-income. Another feature of the different volatility indexes is that the 1-month VIX is more volatile than the 3-month and 6-month indexes.

What if these three volatility indexes break the so-called contango position and become inverted? It doesn’t happen often, and the first time it occurred in 2018 was on Monday, February 5th. Subsequently, the market dropped to 2532.69 on the following Friday, February 9th. To put that move in perspective, the S&P 500 had just hit an all-time high of 2872.87 two weeks before the correction. So is VIX inversion a bearish signal?

Let’s begin with some VIX inversion history (Chart 1). We adopt a strict definition of VIX inversion as follows: 1-month VIX > 3-month VIX > 6-month VIX. We count the turning point of an inversion only, excluding a run of continuous inversions. The VIX indexes are examined from 2008 forward. Since then, 2012, 2013, and 2017 are the only years without any VIX inversion. Noticeably, the average return of the S&P 500 was 23.41% for those 3 years, in contrast to 5.40% for the other years. Among the years with VIX inversions, there are about four inversions on average in each year.

Chart 1. Volatility Indexes Since 2008. Source: CBOE
At first look, VIX inversion might appear to be a non-bullish sign, but we have found a bullish silver lining in the pattern. The inversion per se suggests that the market perceives the 3-month and 6-month trends to be positive. As the result in Table 1 confirms, the 3-month and 6-month returns following the turn to a VIX inversion are higher than the contango cases. Particularly, the 6-month spread is almost 183 bps. Moreover, last time the VIX inverted in October was in 2014, which had a 6.99% 3-month return and 11.74% 6-month return.
Table 1. 3- and 6-Month Returns After VIX Inversion. Data source: Bloomberg

Lastly, betting on VIX inversion does not appear to be a tradable strategy, as it does not happen often. Therefore, you are not likely to trade it successfully.*Data updated on October 5, 2018.

Leo Chen, Ph.D.
Portfolio Manager & Quantitative Strategist
Email | Bio


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Market Volatility ETF Portfolio 3Q 2018 Review

The US equity market has had a strong third quarter this year. Our quantitative strategy benefited from the market rebound in July and August and took profits off the table at the end of last month. We have been sitting in all cash and waiting for the next entry signal since we exited near the market top.

 

Cumberland Advisors - Quarterly Review - Market Volatility ETF
 

The S&P 500 large-cap index is up about 9.69% YTD (ex-div) and hasn’t significantly deviated from where the market was at the same time last year. These numbers are certainly making investors happy, since the 10-year Treasury is yielding only about 3% nowadays. Although 2017 and 2018 show some similarities in the overall numbers, the detailed paths are quite different. We may still remember the ultra-low-volatility regime in 2017. But after a correction in February and some large spikes in volatility in the first quarter of 2018, we haven’t seen many short-volatility trades floating around this year. Needlessly to say, it was painful for the “short-vol” funds just half a year ago.
However, the third quarter proved to be another contrarian case. Market volatility continued its downward trend, falling to a 11-handle (Figure 1 below) and showing signs of relief after the spiral jump back up in February. While the 50.85% drop in VIX since April helps to explain the market comeback so far, it may be a misleading signal with regard to the underlying market. With the heated tariff war and midterm election coming up, we caution our readers not to interpret the VIX too literally. As we learned in the first quarter, VIX can spring up drastically in no time.

Chart 1. VIX since April 1, 2018. Chart source: Yahoo! Finance
The spread between the S&P 500 and VIX (Figure 2 below) continues in the third quarter: VIX is down over 20% while the market is up over 6%. This trend may be a sign of rising complacency in the market, as this type of widening does not typically happen during summer swoons. Nevertheless, as we always remind our readers, although we decided to go to cash with our quantitative strategy, that is not a short call from our model. Of course, “cash is king” has its merits. Our strategy is not to be afraid to hold cash and to be ready to enter when the time is right.

Chart 2. S&P 500 vs. VIX in 3Q 2018. Chart source: Yahoo! Finance
*Data updated on September 20th, 2018.
Leo Chen, Ph.D.
Portfolio Manager & Quantitative Strategist
Email | Bio

 


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Market Volatility ETF Portfolio 2Q 2018 Review

While the U.S. stock market had a long overdue correction in February of 2018, the first quarter ended merely flat eventually. Continuing from the rebound since February low, the stock market kept rising strongly in the second quarter.

Cumberland Advisors - Quarterly Review - Market Volatility ETF
 

Out of the three major indexes, the NASDAQ is leading the race by miles ahead. The technology-heavy index has closed at all-time highs for 20 times as of June 15 this year, piling upon last year’s record of 72 times. Although the Dow Jones Industrial Average had comparably 71 closing all-time highs in 2017, the Dow has only closed at all-time highs for 11 times this year, all of which were from January 2018. Moreover, the NASDAQ has also outperformed the Dow by roughly 10% including dividends during the first half of 2018. Standing in between the NASDAQ and the Dow, the popular benchmark S&P 500 has been relatively benign in 2018. Although this large-cap index has risen over 2% in both May and June so far, investors certainly have poured more interest into the small caps in the meantime, evidenced by the second quarter performance comparison below.


Chart 1. S&P 500 vs. Russell 2000 in 2Q2018. Chart source: Yahoo! Finance.

The second quarter has seen a lower volatility level compared to the first quarter. The VIX has calmed from above 20 down to 11 handle since April. Some major factors such as the alleviated concern over trade war and the improving U.S.-North Korea relations most likely contributed he significant downward shift in volatility. However, there are still some dark clouds in the near-blue sky. For example, the crude oil is still fighting to hold the $60-$70 per barrel ground. Not surprisingly, the oil volatility OVX has gone up in the second quarter.


Chart 2. S&P 500 Volatility VIX vs. Crude Oil Volatility OVX in 2Q2018. Chart source: Yahoo! Finance.

The recovery from the February correction has shown the resilience in the stock market. It is likely that the stock market can move higher in the next quarter if the volatility remains at or below the current level. However, as some sectors such as technology have demonstrated in the second quarter, not all sectors will be able to take advantage of the calming volatility equally this year. Perhaps, 2018 will be a year that favors active investors.

Leo Chen, Ph.D.
Portfolio Manager & Quantitative Strategist
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Causality

On day 1 our econometrics professor warned us to be careful with correlation: A strong correlation doesn’t necessarily mean causality. This is the case with the VIX. It’s closely related to the S&P 500 with a negative correlation, but the relationship may not be causal. I will never forget the example our professor gave us: The number of people who have drowned by falling into a swimming pool, it turns out, is highly correlated with the number of movies Nicolas Cage has filmed. Unlike school vending machines that can be causally linked to childhood obesity, Nicolas Cage didn’t need a scientific study to prove his innocence.

However, investors sometimes mistakenly assume causality between seemingly related events. If a rise in VIX is accompanied by some down days in the stock market, did the VIX cause stocks to fall? To answer this question, we need to know how the VIX is calculated. The VIX uses factors from the options market, one of which is the observed forward index price calculated by out-of-money options in the short term. But this correlation calls for caution about endogeneity: The VIX is derived from traders’ perceptions about the future, but actual futures prices also affect traders’ perceptions. How can we be sure that the VIX causes stock price to change? If anything, VIX is more likely the effect than the cause in this relationship. Analogously, the more firemen are sent to a fire (effect), the bigger the fire is (cause). From the perspective of future perceptions, VIX appears more likely to correspond to the firemen who respond to the fire in numbers according to its size than to the fire itself.

What is causation as opposed to correlation, then?  Here’s an example of causation: Consuming alcohol can cause a hangover the next morning. Unfortunately, causality is not as easy to identify in finance as it is in the case of having too much to drink. Oftentimes, what appears to be causation turns out to be just correlation. But why is causation so important for investors? The reason is simple: If a variable can cause stock prices to change, then it is a predictor. Who wouldn’t like to know tomorrow’s stock prices? If we have causation, we have a way to anticipate what’s coming. Why is it so difficult to identify a causal relationship? It is not because there is a limited supply of crystal balls; instead, the stock market is too complex. The stock market is sensitive to all information pertaining to the future. Therefore, it’s not just one variable but many that affect the stock market. Those variables can be as simple as some new product or quarterly earnings, or more intricate ones such as a tax bill or an interest rate change.

At this point we seem to be mired in a paradox: If there are so many factors that can cause stock prices to change, why is it so difficult to identify one? The answer once again falls upon the complexity of the market. Investors and financial engineers have studied the stock market extensively. Although there have been many models, such as the Fama-French three-factor model, created to attempt to explain stock prices, unfortunately, no model yet invented captures the complex interactions of the stock market. This limitation makes it extremely difficult to test any variable against the so-called benchmark. Currently, one of the most-used ways to mitigate this problem is to test one variable at a time against a bundle of existing factors. Nevertheless, our modern research methodologies still only allow us to conclude with a probability rather than certainty. To complicate matters further, the stock market is dynamic. This challenges any model used to predict the stock market. In other words, a factor may have a causal relationship with the stock market at a certain time but not at all times. The explanation is straightforward. If a factor were known to cause stock prices to change, then investors would use that factor repeatedly. By Goodhart’s Law, that factor would not be rendered ineffective over time.

Finally, the key difference between causation and correlation is simple. Causation means A happens before B, while correlation suggests A and B both happen at the same time. Let’s use the figure below, for instance. By rule of thumb, household income is likely to lead personal expenditures, which may explain why there is a slowdown in income preceding each decrease in expenditures.

Personal Consumption Expenditures and Median Household Income in the United States. Source: St. Louis Fed. 
Leo Chen, Ph.D.
Portfolio Manager & Quantitative Strategist
Email | Bio

Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Stop Saying Volatility Is a Bad Thing

Excerpt below:

Hardly a day went by in 2017 without some pundit bemoaning the lack of volatility in financial markets. They worried about complacency, implying that the Goldilocks-like environment that enveloped markets was a recipe for disaster. With volatility on the rise, you would think the handwringing would diminish. It hasn’t. Now, the pundits are worried the big swings in asset prices of the last few months portend doom.

Somewhere along the line, the word “volatility” became code for a declining stock market. The reality is that rising volatility as measured by the CBOE Volatility Index, or VIX, “is only a reflection of volatile movements in the market — it is not a predictor of future returns,” David Kotok, the head of Cumberland Advisors, sent in a Friday note written by Leo Chen Ph.D. to the wealth management firm’s clients. Although the VIX has risen from a record low of below 10 in November to above 30 in February, that doesn’t necessarily portend trouble. Chen points out that whenever the VIX has doubled in a period of three months, the S&P 500 has gained an average of 6.31 percent in the following six months. The S&P 500’s average six-month return is 4.37 percent since 1990.

The reasons for last year’s low volatility are pretty apparent. First, there’s little room for surprise when the Federal Reserve is telling you what it’s going to do, when it’s going to do it and by how much. Second, the Trump administration was focused on such market-friendly moves as reducing regulations and cutting corporate taxes.

Read the full article on Bloomberg.




Dow Closes the Week Up 427 Points–the Hard Way

Excerpt below:

Another week, another reason to wonder: Is the correction really over?

The market found its footing this past week, as the Dow Jones Industrial Average advanced 427.38 points, or 1.8%, to 24,360.14, while the Standard & Poor’s 500 index rose 2%, to 2656.30, and the Nasdaq Composite gained 2.8%, to 7106.65.

Dow Closes the Week Up 427 Points–the Hard Way
It was the second time in the past four weeks that the S&P 500 followed a down week with a gain, and it did so despite concerns that President Donald Trump would launch a missile strike against Syrian targets, amid continued chaos in Washington, and after a lackluster response to better-than-expected earnings from JPMorgan Chase (ticker: JPM), Citigroup (C), and Wells Fargo (WFC).

Sure, the recent volatility can’t help but feel stressful, given that it’s nearly twice what it was last year. But a doubling of the VIX doesn’t have to be a harbinger of future pain, according to Cumberland Advisors quantitative strategist Leo Chen. He notes the S&P 500 has returned an average of 6.3% over the six months following a doubling of the VIX. “The VIX certainly has felt feverishly high relative to the market in the past two months,” he explains. “Fortunately, a doubled VIX may not be bad news for the market.”

Read the full article at Barron’s.




The VIX and the S&P 500-An Equity Market Duet

Most market participants have accepted that 2018 is unlikely to be another low-volatility year like 2017, but how do we translate the rising volatility into our market forecast? Some Wall Street bulls such as RBC’s Lori Calvasina have revised their year-end forecasts down recently.* Are those revisions because of the higher VIX?

First, given that the VIX measures the implied volatility of the S&P 500, the negative correlation between the VIX and the S&P 500 is no surprise. Moreover, not only is the correlation significant, the co-movement between the daily changes of these two indexes is rather close. Metaphorically, if we consider these two indexes as if they were two sound waves, as shown in Figure 1, then both the timing and the intensity of the movements in the indexes make the VIX and the S&P 500 an equity market duet. (Data source: Bloomberg)


Figure 1. Co-movement between the S&P 500 and the VIX

 

Does a rising VIX signal lower equity returns? This may be a misconception among many investors. A rising VIX is usually accompanied by sequential negative market returns, the magnitude of which can be substantial, particularly during a rapidly increasing VIX environment. Therefore, we tend to associate lower returns with higher VIX. However, by definition, higher VIX is only a reflection of volatile movements in the market – it is not a predictor of future returns.Nevertheless, the VIX is still powerful in terms of explaining market returns. If we assume that the relationship between the VIX and the S&P 500 is linear for the sake of simplicity, then we can capture a -1:0.1145 movement ratio between the VIX and the large-cap index. In another words, a roughly 9% increase in the VIX translates into a 1% drop in the S&P 500. But this oversimplification is not realistic, since we can see from Figure 2 that the distribution of the VIX is rather skewed compared to the S&P 500. Statistics 101 tells us that the relationship is not linear. Instead, if we look at the sunflower plot in Figure 3 (yes, sunflower plot is a scientific term), the relationship is also unlikely a complex curve; rather, the VIX is more subject to drastic movements than the S&P 500 is.


Figure 2. VIX distribution vs. S&P 500 distribution

Figure 3. Sunflower plot of the S&P 500 and VIX

Knowing the characteristics of the relationship between the S&P 500 and the VIX, we can now explore what opportunities are hidden in a rising VIX market. Although the historical average of the VIX is about 19.35, the VIX certainly has felt feverishly high relative to the market in the past two months. That impression is understandable, because the VIX has more than doubled since the single-digit VIX period not long ago. Fortunately, a doubled VIX may not be bad news for the market. Historically, the S&P 500 has had a 6.31% six-month return, on average, following a doubled VIX within a three-month horizon, while the S&P 500’s average six-month return is 4.37% since 1990. Additionally, if the one-month average of the VIX reaches above 25 after the VIX doubles, the S&P 500 has had a 9.90% six-month return on average in the past. That return is more than twice the average six-month return in the market.

Historically, if the six-month average in the VIX drops more than 30% and the VIX dips below 13, the following six-month S&P 500 return has never seen a loss and has averaged 7.09% since 1990. Uncanny, isn’t it?

Leo Chen, Ph.D. 
Portfolio Manager & Quantitative Strategist
Email | Bio
*Source: https://www.cnbc.com/2018/04/10/rbc-cuts-sp-500-forecast-for-2018-as-political-obstacles-for-stocks-pile-up.html.

Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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