Volatility metrics can be "Sticky" after a Market Crash

VTS Community,

At the heart of my investing success over the last 15+ years is what I call Tactical Rotation through Volatility Targeting.  This is the system of setting up different Volatility ranges, and then assigning the asset classes to them with the highest probability of success.

Now a majority of the time we are just in aggressive positions like Short Volatility or long equities benefiting from the long-term uptrend in the market.  However, there are times when we need to cycle into safety to protect capital.  We saw that recently with our exit to safety on July 24th, well before the markets really fell off. 

I went over this in detail in the recent Volatility Targeting video  (click here if you missed it)  that we don't exit to safety to avoid 5-10% market corrections.  It's nice when it happens, but the real reason we do it is to avoid, and potentially profit from, extended market declines.

I for one do NOT plan to ride the stock market down 40-50% when the next recession hits!  I'd like to be either in safety, or in positions that can potentially make a profit.

Volatility metrics can remain "sticky" after a spike

After every major Volatility spike though, at some point the market is going to settle down.  What goes up must come down right?  When that happens, the Volatility metrics themselves can remain what I call "sticky."  This means that those levels can stay elevated for several days after the market has already started to recover. 

It can be a little frustrating watching the market start to go back up, and watching those aggressive market positions like short Volatility go up again while we're still in safety.

As an example, here's the last 3 days for the SVXY:

Tuesday:  +9.74%

Wednesday:  +2.25%

Thursday:  +3.91%

We can compare that to us sitting in GLD Gold for safety

Tuesday:  -0.80%

Wednesday:  -0.07%

Thursday:  +1.57%

It can be frustrating watching that differential, while we're waiting for Volatility metrics to decline enough to get us back into the aggressive positions.  There's 2 reasons why we should not worry about this "sticky" metric issue: 

1)  We have a larger purpose

Remember, it's not about avoiding 5-10% market corrections.  It's really about avoiding the bigger damage that comes every several years.  Sometimes people need a reminder of just how long it can take the stock market to recover after a major crash if you don't cycle out into safety.

- After the financial crisis in 2008, the S&P 500 on an inflation adjusted basis didn't break to new highs until 2013.

- Extending back to the dot.com bust, the S&P 500 on an inflation adjusted basis didn't break above all time highs for 17 years.

The average recession cycle in the United States is about 6-7 years.  We simply can't afford to allow our portfolio to remain in a drawdown for 5-10 years or longer when the next one hits.

We MUST have the discipline to move to safety when the market is giving us Volatility warning signs.  Preservation of capital is everything! 

2)  Losses are more costly than gains are beneficial

This gets back to the mathematical problem that the larger a drawdown becomes, the more exponentially difficult it is to recover from.

- A 20% drawdown isn't that big of a deal, as it only requires a 25% subsequent rate of return to get back to break even.

- A 40% drawdown is a lot harder to recover from because it now requires a 67% rate of return after that to get back to break even.

When we're talking about Volatility ETPs like SVXY, on a buy & hold basis it can easily see a drawdown in the 70 - 80% range, or even higher.  Now the recent drawdown for SVXY  (at least so far)  wasn't that bad.

It was only down 40% at the low which means it requires a 67% rate of return afterwards to get back to break even.  Maybe that will happen in a month or so, we'll see.

Again though, we're not trying to avoid these small market corrections.  We're trying to avoid the big 80% or more drawdowns that can take many years to recover from.

Even still though, down 40%, it needs 67% to break even, and it's not even close.  We can compare our safety position of GLD Gold to what it would have looked like if we stayed in the SVXY

Even on a relatively small market correction of only 10%, it's still beneficial to exit to safety.  As of right now we're still showing a positive differential in our strategy of over 20%.  We can do the final calculation in a few months and see the end result, but can you imagine how great it will feel to be in safety when the market is down 40% or more right? 

The alternative to safety discipline is far worse

You all know I'm not a doom and gloom type of person.  I'm not all over Twitter talking about how terrible the economy is and how the next recession will wipe everybody out.  On the contrary, roughly 2/3's of the time I'm in aggressive market positions and I always think that the default for all investors should be net long equities / net short volatility.

I've been investing full time since retiring from professional golf in 2005.  I've seen several major market crashes of 20% or more, and I've traded through the Financial Crisis when stocks were down 56%.

Trust me, things can get a whole lot worse than we saw this past week.  Respecting how far markets can fall means I will always have the discipline to move to safety when our VTS Volatility Barometer says so.

It doesn't always pay off.  Sometimes when the dust settles it turns out to not have been necessary.  Trust me though, there will be a time when it absolutely is, and a small fortune can be made in the differential between safety and crisis.

Head down, have discipline, trade the signals like a robot, rinse repeat...