As you know I think this trading range will be resolved by an upside breakout. One piece of evidence for this view is that market sentiment is still quite bearish. You can see this in the 5 day moving average of the CBOE put-call ratio which in late August reached the highest level of the past three years and is still hovering near that high. Another reason for expecting an upside breakout is the sequence of higher lows visible within this one month trading range.
Yet another reason for expecting an upside breakout has to do with the gradual reduction of volatility we has seen during the past month. To explain why this is so we have to take a look at a new class of investment strategies followed by many money managers nowadays.
These strategies go under the names of risk parity and volatility targeting strategies and have become very popular over the past 10 years. These strategies has amplified the normal market tendency to be more volatile in down swings than in upswings. Moreover, the have the effect of pushing stock prices lower as volatility increases and higher as volatility decreases.
The basic goal of both these strategies is to maintain a constant level of risk in an investment portfolio over time. Risk arises from fluctuations in the investment return on a given asset over time and from the correlation between such fluctuations among various classes of assets at any given time.
In market downtrend, when fear predominates, short term fluctuations in returns grow larger (the market gets more volatile) and, worse, the returns on different asset classes tend to "go up and down together", so that their short run returns are highly and positively correlated. When returns are highly correlated it is difficult to reduce volatility risk through diversification so the volatility risk associated with any give portfolio allocation increases for that reason alone.
Thus in a market downtrend one generally finds that the volatility risk associated with any fixed portfolio allocation will increase. The opposite happens in an uptrend - volatility risk associated with any fixed allocation will decrease. This phenomenon is just the natural behavior of markets which one can observe in the historical record.
Over the past 10 years risk parity and volatility targeting strategies have become very popular. Typically managers who employ these strategies try to compensate for the changes in portfolio volatility risk by changing the leverage used in their portfolios, borrowing more to invest when volatility is low and reducing their borrowings and hence their leverage when volatility is high. From an investment point of view such behavior makes very good sense. But consider the effect it will have upon market behavior.
High volatility is generally associated with stock market downtrends. How do risk parity managers respond when the stock market goes down and volatility increases? They start to de-lever their portfolios, i.e. they sell stocks - the most volatile of the big asset classes - and they reduce their borrowings, thus reducing their exposure to all other asset classes as well. Worse, they really don't care much about the prices they get when they sell since their mandate is to reduce volatility risk and let the returns take care of themselves.
Consequently risk parity and volatility targeting strategies amplify the natural volatility seen in stock market downtrends and, if anything, make these declines bigger than they normally would be. The more investor capital devoted to such strategies the bigger this amplification of downtrends will be.
The reverse happens in stock market up trends. I have frequently remarked over the past four years how unusually quiet the stock market has been during uptrends and that the further the uptrend has gone the quieter the market has become. But quiet markets encourage those following volatility strategies to buy stocks and to lever up their portfolios. So a low volatility up trend will go much further than normal, feeding itself for this reason alone.
But unlike the situation in a downtrend volatility risk management strategies by themselves won't dampen volatility in an uptrend. So while these strategies had the effect of sending the averages higher than they might ordinarily have gone there still remains the mystery of oddly low volatility during the advancing phases of the bull market.
Here is where the Fed's quantitative easing polices come in. The main effect of QE programs is to stabilize the growth rate in nominal GDP. This has the effect of reducing the volatility of all investment returns. So in effect the Fed was in the business of reducing volatility and this itself led to increasing leverage and increasing allocations to the stock market on the part of managers who employ risk parity and volatility targeting strategies.
But unlike the situation in a downtrend volatility risk management strategies by themselves won't dampen volatility in an uptrend. So while these strategies had the effect of sending the averages higher than they might ordinarily have gone there still remains the mystery of oddly low volatility during the advancing phases of the bull market.
Here is where the Fed's quantitative easing polices come in. The main effect of QE programs is to stabilize the growth rate in nominal GDP. This has the effect of reducing the volatility of all investment returns. So in effect the Fed was in the business of reducing volatility and this itself led to increasing leverage and increasing allocations to the stock market on the part of managers who employ risk parity and volatility targeting strategies.
Now let's consider how these strategies will influence the behavior of stock prices going forward. When the stock market averages fluctuate within a trading range as they have for the past month the natural tendency is for volatility to decrease as the trading range extends over time. This reduces the apparent risk associated with any fixed portfolio allocation.
Consequently this natural reduction in volatility should encourage managers of risk parity and volatility targeting portfolios to start increasing their stock market allocations and increase their borrowings to lever up their portfolios. So the result of this natural reduction of volatility should be a new up trend in stock prices.
This is yet another reason for expecting an upside breakout from this range.
This is yet another reason for expecting an upside breakout from this range.
