May 6 Weekend Update - Volatility as an Indicator

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Summary

• Stay the course for now.  None of the TSP funds are indicating a move to cash, but yes, they are pulling back somewhat.  Let the markets decide what we should do, do not try to anticipate.
• Since I went long on 5/2, my account has dropped a total of -1.565%.  By reference, the C-Fund has dropped -1.526%, the S-Fund has dropped -2.222%, and the I-Fund has dropped -3.748%.  The F-Fund, which is a bond fund, has increased +0.528% in this time.
• The present allocation of 97% C-Fund, 1% F-Fund, and 2% S-Fund is keeping us in the most stable portfolio combination as of May 6.  Any deviation from this portfolio will introduce more volatility at a greater rate than recent gains (taking more risk for the same or less gains, not advised).
• For the record, the 12-month personal rate of return on this portfolio is 10.38%.  Note that this includes the period 4/22/10 to 9/7/10, where I sat the market out in cash due to taking some time off.  Drawdown has been low single digits over the past year, yielding a Calmar Ratio of just over 3.0.

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Volatility as an Indicator

Volatility is a measure of how much a stock moves in a given time frame.  It's a squirrelly beast when it comes to the markets, because future volatility over the next 30 days and beyond has a big influence on option prices, and correspondingly, to money flow within the markets.  

The ETF VXX gives a reasonable view of volatility as reported in the market.  I say "reasonable", because it's not a perfect match.  The Yahoo! symbol ^VIX is the CBOE index for volatility for the next 30 days, but we can't trade it directly.  VXX is the closest ETF to "the VIX", with a coefficient of regression of 0.82 (R^2 = 1.00 = perfectly correlated).  VXZ is related to "the VIX" in that it is a tradeable instrument that is an estimate of volatility beyond 30 days.

For the last several weeks, the VIX has been really low, as in multi-year lows.  This means that folks think that the markets are going to hum along nicely with low volatility.  Correspondingly, VXX and VXZ have been very low too.

When the markets begin to jump around, VXX moves faster than VXZ.  The two are close (R^2 = 0.93), but VXX jumps faster.  This allows us to compare the two, and when we do, we get a view of the market in general.

Take a look at the following picture:

This picture is available here; you can bookmark the link.

What is shown in the lower graph is the ratio of VXZ (longer-term expected volatility) divided by VXX (shorter-term expected volatility).  The scale is a weekly scale.  The blue line is a 7-week moving average.

When the bars are trading below the blue line we can expect rougher roads ahead.  Right now the most recent week saw a drop, but not a penetration below the blue line.  This is bullish overall.

When the blue line is pointing upward, we typically can expect the markets to move upward.  The eye has a hard time discerning this, so I included a slope line at the top of the graph.  The slope line tells us with more detail about what the ratio VXZ:VXX is doing.

Right now, the slope is positive at +0.06 -- VXZ is growing faster than VXX, -- OR -- VXX is getting smaller at a faster rate than VXZ.  Either way, the markets are still in an up trend, as far as FUTURE expectations are concerned.  

The dropping VXZ:VXX ratio simply means that we are slowing -- but because the value is positive at +0.06, we are still in an up trend.

We can still move upward in the markets if the slope line is pointing downward.  The key aspect is whether the slope line has a positive value -- it is presently +0.06 -- or if it has a negative value.  It should be clear that once the VXZ:VXX ratio crosses below the 7w average line, OR the slope line turns negative, that we should be out of the markets.  

Until then, stay the course.  Remember though, your crystal ball is as good as mine.

Check this chart as time allows -- use the link provided above.

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Remember, you are responsible for your own investment decisions, and I am not.  Please do your own diligence, and please take ownership for your actions.

Regards,

pgd