After a 186% rise in the S&P 500 over the course of the past 6 years, fears of a pullback have increased significantly this year.
We look at volatility cycles to see if the general fear and rhetoric is supported by our systematic indicators.
Our risk indicator stays low for the S&P 500 showing that the trend cycle is still intact.
After a 186% rise in the S&P 500 over the course of the past 6 years, fears of a pullback have increased significantly this year. Concerns of a pullback are coming from several fronts.
1. Reduced quantitative easing stimulus by the Fed.
2. Fears of disinflation as reflected in falling long-term yields in the bond yield curve.
3. Cautious remarks by the Fed as well as prominent hedge fund investors. E.g. David Tepper of Appaloosa Management has cut his long equity exposure 60% from 100% and is nervous about the markets as per his comments on CNBC.
Our approach of assessing market risk is decidedly systematic rather than fundamental. The key systematic indicator we look at is volatility cycles. At a very basic level, there are three types of market environments based on volatility:
1. Trending Market
This market is defined as one that is made up of a series of smaller periods with a relatively constant rate of return, such that the instantaneous volatility of returns as measured per smaller time slice is close to zero.
2. Shock Market
This market is one that is made up of a series of smaller periods with high volatility and low volatility.
3. Noise Market
This market is one that is made up of a series of smaller periods with a relatively constant volatility. A noise market bears no trend.
Source: Tiger Technologies
Furthermore, what we have found in studying the volatility cycles in the S&P 500 since 1950 is the following pattern in most long-term volatility cycles:
TREND followed by NOISE followed by SHOCK followed by TREND.
Here are a few historical examples that show such patterns. In the charts below we show the S&P 500 index on the left axis and our proprietary risk indicator on the right axis. The risk indicator is a function of the size of the daily returns and the daily volatility of the index. When the daily returns are positive and the volatility of those returns is low, the risk indicator is negative. A negative risk indicator implies that the market is in a nice bull trend. A neutral to slightly positive risk indicator implies that the S&P 500 is in a noisy sideways channel and a high positive risk indicator will show a volatile bear market.
In the chart below we can see a trending S&P 500 market from 1994 to the end of 1999, followed by a noise period in 2000 and a shock bear market in 2001-2002.
In the subsequent period from 2003-2009 we can see a trending S&P 500 market from 2003 to 2007 with 2 short periods of noise in 2004 and 2006. The trend period ended in 2007 which was followed by a noise period in the latter half of 2007 and then a large shock period in 2008.
Source: Tiger Technologies
This brings us to the current period from mid-2009 to the present. Here once again we can see a period of low risk and a trending S&P 500 with a short break in 2011 where we saw a noise period during the European debt crisis.
But the curious part is that at present, i.e. in May 2014, we do NOT see any pickup in our risk indicator. Despite the slowdown in the pace of S&P 500 appreciation, our risk indicator, which is a measure of returns and volatility, stays extremely low.
Given the current low risk technical environment combined with the fact that the S&P 500 is up 5% for the year we are finding more comfort in the Q1 statistical analysis we had presented back in April which showed that based on the Q1 returns since 1952, we can expect a positive year for 2014 with returns in the neighborhood of 10%.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Tiger Technologies, LLC unless a client service agreement is in place. Nothing in this presentation should be construed as a solicitation or offer, or recommendation, to buy or sell any security, or as an offer by Tiger Technologies, LLC to provide advisory services. Investment management services are offered only pursuant to a written Customer Agreement, which investors are urged to read and carefully consider in determining whether such agreement is suitable for their individual facts and circumstances.