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Summer Squall or the Start of Hurricane Season?

Long Term Strategy Designed to Weather the Big Storms

Fol­low­ing the sharp draw­down of August 20–25, the mar­ket has hov­ered around cor­rec­tion lev­els, defined as a drop-off of more than 10% from its highs in May. From here, we believe there are two like­ly direc­tions the mar­ket can take: a quick recov­ery or a long, steep bear mar­ket. While it is pos­si­ble that the mar­kets remain flat and con­sol­i­date over the com­ing months or years, we at Swan do not view that as a like­ly pos­si­bil­i­ty.  Our think­ing par­al­lels a recent New York Times arti­cle by Yale’s Robert J. Shiller, “Ris­ing Anx­i­ety That Stocks Are Over­priced.”

Swan’s cre­do is that we do not engage in mar­ket-tim­ing, but it is worth dis­cussing the impact dif­fer­ent mar­ket sce­nar­ios might have on Swan’s Defined Risk Strat­e­gy.  After all, Swan has a track record exceed­ing 18 years and has suc­cess­ful­ly weath­ered many dif­fi­cult mar­kets.  While past per­for­mance does not guar­an­tee future results, it can serve as a use­ful guide­post.

One pos­si­ble sce­nario is that the mar­ket can quick­ly recov­er from this bout of insta­bil­i­ty and con­tin­ue on its upward tra­jec­to­ry as if noth­ing hap­pened. Such sce­nar­ios have hap­pened before- think of the Russ­ian default/Long-Term Cap­i­tal Man­age­ment deba­cle of August 1998, the “flash crash” of May 6th, 2010, or the Trea­sury down­grade of August 2011.  Such a sce­nario is favor­able to Swan’s income-gen­er­at­ing strat­e­gy, which relies par­tial­ly on mod­er­ate lev­els of volatil­i­ty in the mar­kets to be prof­itable.  For most of 2015 the VIX, com­mon­ly used as a proxy for volatil­i­ty or “fear”, has been com­pla­cent and stuck in the low/mid-teens.

 

VIX level 2015 - Summer Squal or the Start of Hurricane Season|Swan Blog

Typ­i­cal­ly after a cor­rec­tion there is what we call a “hang­over effect” where wor­ry creeps in to the mar­ket and short option trades are able to com­mand a much high­er lev­el of pre­mi­um, as seen in the graph below.  Such peri­ods have his­tor­i­cal­ly been quite favor­able to Swan’s income trades. See more in our post on recent mar­ket volatil­i­ty.

Sudden Corrections and VIX Spikes - Summer Squal or the Start of Hurricane Season|Swan Blog

Alter­na­tive­ly, this sell-off could her­ald the com­ing of a long-pre­dict­ed bear mar­ket, fol­low­ing an almost unin­ter­rupt­ed bull mar­ket ini­ti­at­ed in ear­ly March 2009. It is impor­tant to remem­ber that the DRS was designed specif­i­cal­ly for the lat­ter sce­nar­ios, the big bear mar­kets that wipe out investor wealth. In such envi­ron­ments tra­di­tion­al asset allo­ca­tion, stock-pick­ing at mar­ket tim­ing often fail to ade­quate­ly address mar­ket risk. The DRS was cre­at­ed to out­per­form over a long peri­od of time, not a short peri­od of time.

The graph below shows the per­for­mance of the DRS Select Com­pos­ite and the S&P 500 dur­ing the dot-com crash of 2000-02 and the Finan­cial Cri­sis of 2007-08, nor­mal­ized to the same scale.  Dur­ing these envi­ron­ments, two of the three com­po­nents of the DRS are usu­al­ly con­tribut­ing val­ue.

Bear Market Performance of DRS vs SP 500 Index -- Summer Squal or the Start of Hurricane Season|Swan Blog

First of all, the long-term put option used to hedge mar­ket risk becomes increas­ing­ly valu­able the more mar­kets sell off.  If mar­kets sell off sig­nif­i­cant­ly, Swan has his­tor­i­cal­ly used the oppor­tu­ni­ty to har­vest gains in the put and re-invest in the equi­ty mar­ket when the mar­kets are at depressed lev­els. Sec­ond, the increased volatil­i­ty dur­ing bear mar­kets has his­tor­i­cal­ly been con­ducive to the DRS’s income gen­er­at­ing strat­e­gy.

It is also impor­tant to acknowl­edge that no strat­e­gy will always work in every con­ceiv­able envi­ron­ment. Faced with that real­i­ty, Swan has strate­gi­cal­ly cho­sen to accept poten­tial short-term loss­es from sell­ing short term options, as seen dur­ing this recent cor­rec­tion, in exchange for longer term growth oppor­tu­ni­ties. More often than not such trades are prof­itable, and help make the long-term, mar­ket pro­tec­tion pos­si­ble. In the short-term, the DRS might appear less appeal­ing than alter­na­tive strate­gies focused on short-term mar­ket move­ments, rather than a longer term growth objec­tive. How­ev­er, the DRS was designed to be suc­cess­ful over full mar­ket cycles, extend­ing years, not days.

For a detailed white paper on this top­ic, click here.

 

Marc Odo, Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions - Swan Global InvestmentsAbout the author: Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Direc­tor of Invest­ment Solu­tions, is respon­si­ble for help­ing clients and prospects gain a detailed under­stand­ing of Swan’s Defined Risk Strat­e­gy, includ­ing how it fits into an over­all invest­ment strat­e­gy. For­mer­ly Marc was the Direc­tor of Research for 11 years at Zephyr Asso­ciates.

 

Impor­tant Notes and Dis­clo­sures:

S&P 500- The S&P 500 Index is a mar­ket cap weight­ed index of 500 wide­ly held stocks often used as a proxy for the over­all U.S. equi­ty mar­ket.

The CBOE Mar­ket Volatil­i­ty® Index (VIX) shows the market’s expec­ta­tion of 30-day volatil­i­ty. It is con­struct­ed using the implied volatil­i­ties of a wide range of S&P 500 index options. This volatil­i­ty is meant to be for­ward look­ing and is cal­cu­lat­ed from both calls and puts. The VIX is a wide­ly used mea­sure of mar­ket risk and is often referred to as the “investor fear gauge”.

Source for VIX and S&P 500 data: CBOE and Morn­ingstar

Swan Glob­al Invest­ments, LLC is a SEC reg­is­tered Invest­ment Advi­sor that spe­cial­izes in man­ag­ing mon­ey using the pro­pri­etary Defined Risk Strat­e­gy (“DRS”). SEC reg­is­tra­tion does not denote any spe­cial train­ing or qual­i­fi­ca­tion con­ferred by the SEC. Swan offers and man­ages the DRS for investors includ­ing indi­vid­u­als, insti­tu­tions and oth­er invest­ment advi­sor firms. Any his­tor­i­cal num­bers, awards and recog­ni­tions pre­sent­ed are based on the per­for­mance of a (GIPS®) com­pos­ite, Swan’s DRS Select Com­pos­ite, which includes non-qual­i­fied dis­cre­tionary accounts invest­ed in since incep­tion, July 1997, and are net of fees and expens­es. Swan claims com­pli­ance with the Glob­al Invest­ment Per­for­mance Stan­dards (GIPS®). All data used here­in; includ­ing the sta­tis­ti­cal infor­ma­tion, ver­i­fi­ca­tion and per­for­mance reports are avail­able upon request. The S&P 500 Index is a mar­ket cap weight­ed index of 500 wide­ly held stocks often used as a proxy for the over­all U.S. equi­ty mar­ket. Index­es are unman­aged and have no fees or expens­es. An invest­ment can­not be made direct­ly in an index. Swan’s invest­ments may con­sist of secu­ri­ties which vary sig­nif­i­cant­ly from those in the bench­mark index­es list­ed above and per­for­mance cal­cu­la­tion meth­ods may not be entire­ly com­pa­ra­ble. Accord­ing­ly, com­par­ing results shown to those of such index­es may be of lim­it­ed use. The adviser’s depen­dence on its DRS process and judg­ments about the attrac­tive­ness, val­ue and poten­tial appre­ci­a­tion of par­tic­u­lar ETFs and options in which the advis­er invests or writes may prove to be incor­rect and may not pro­duce the desired results. There is no guar­an­tee any invest­ment or the DRS will meet its objec­tives. All invest­ments involve the risk of poten­tial invest­ment loss­es as well as the poten­tial for invest­ment gains. Pri­or per­for­mance is not a guar­an­tee of future results and there can be no assur­ance, and investors should not assume, that future per­for­mance will be com­pa­ra­ble to past per­for­mance. All invest­ment strate­gies have the poten­tial for prof­it or loss. Fur­ther infor­ma­tion is avail­able upon request by con­tact­ing the com­pa­ny direct­ly at 970–382-8901 or www.swanglobalinvestments.com.   039-SGI-090115

By | 2017-08-24T11:33:59+00:00 September 1st, 2015|Blog|Comments Off on Summer Squall or the Start of Hurricane Season?