Why Bonds are better than Stocks during Low Volatility

VTS Community,

This market continues regularly posting new all time highs, and as of yesterday our Volatility metrics are dipping down into pretty low levels.  The VTS Volatility Barometer dropped below 30 yesterday, something we haven't seen since last December.

This shift to lower Volatility levels means that our VTS Defensive Rotation Strategy is pretty close to rotating out of our current 2x Nasdaq  (QLD) position and into 20+ year Treasury VGLT.  We can see how close the trade dial got yesterday to making the switch.

Why are Bonds better than Equities for low Volatility?

Given that we may actually get that signal to move from QLD to VGLT I think now would be a great time to answer a very common question:

Why do we switch to Bonds in Low Volatility?

One of the great things about having a rules based quantitative system like Defensive Rotation is that I can easily show "what would have happened" if we used different thresholds or asset classes in the past.  It's as easy as plugging in different rules to the system and we can compare anything.

Baseline:  VGLT Bonds during low Volatility

First we can show what the actual performance of those low Volatility VGLT positions actually are.

* Remember, this is ONLY on 13.41% of trading days

VGLT is only held during very low Volatility ranges and they aren't very common, so don't expect the performance to be that stellar.

A very interesting side note, did you know holding VGLT 100% of the time since January 2012 actually has a NEGATIVE return? 

So for the Defensive Rotation Strategy to return 1.82% CAGR holding Bonds on just 13.41% of trading days speaks volumes to the strength of Volatility Targeting.  We don't have to hold asset classes all the time, we can actually just target their highest probability periods.

Comparison:  VGLT Bonds vs holding QLD instead

So now to answer the big question, why rotate out of the QLD at all?  Why not just maintain our Nasdaq exposure even during those extreme low Volatility ranges?

Insert the magic of quantitative investing...

VGLT Bonds CAGR:  1.82%

VGLT Bonds Drawdown:  8.18%

QLD instead CAGR:  1.13%

QLD instead Drawdown:  30.32%

As we can see, not only does the VGLT outperform the QLD in those low Volatility ranges but it does it with much lower drawdowns.  The decision has nothing to do with my personal preference, it's all about the numbers.

Why does QLD stop performing in low Volatility?

The reason for the underperformance is that when Volatility gets to those very low levels, one could argue that the stock market is running on fumes and more likely to reverse course right?

After all, stocks can't go up forever...

When we are at a point in the market cycle when those low Volatility levels are flashing, it's typically towards the end of extended uptrends in the market.

The stock market certainly could continue higher and sometimes it does, but fairly often those do mark where pullbacks become more likely.

It ends up just being a higher probably trade to cycle out of aggressive 2x Nasdaq QLD positions and move into something more consistent.  Within the Defensive Rotation Strategy, VGLT Bonds are the better play during very low Volatility.

Having said all that, obviously I hope this current trend in the market continues so we can continue crushing it with our QLD positions.  It's been a fun ride for a long time now...

I would love to see us set a new record  :)