Falling Market and Rates+Volatility=Underperformance

Includes: DIA, QQQ, SPY
by: Dan Knight

I've seen some posts around the net about the VIX, or market volatility, and the level and change of the 10 year yield. The two measure a couple of powerful and somewhat predictive aspects of the market - the rate to discount future earnings, and a quasi-measure of "fear" or uncertainty.

Mark Hines had an interesting post at VesTopia.com about the bullish indicator of a high VIX level. Others posted about the absolute level of the ratio of volatility to the 10 year yield - the higher the ratio of VIX/10yr, the more bullish. I decided to noodle around with some data to see if I could find some other results.

In general, there are some well known short term indicators that may or might not be exploitable due to reliability and transaction costs. First, when the trailing 22 days (1 month) of the market (S&P 500) are down, the market tends to reverse, and vice versa. I looked at daily data for the S&P 500 and 10 year yield since 1962 to come up with my results.

Since 2000, this market reversal effect was true, and since 1962, the next month's market return after a down month was greater on average than the month after a positive month. So, right now we've experienced a down trailing month(s), so perhaps better things lie ahead near term. However, there is inconsistent predictive power at 3 months and beyond.

Next, I looked at the change in the 10 year yield. Again, it's well known that declining rates bode well for stocks and the results bear that out. The market does better the next month and 3 months out if rates are falling versus rising. Changing volatility is less conclusive. The change in one month trailing daily-annualized volatility sometimes predicts better returns, sometimes not, so the simple measure at looking how volatility is changing isn't reliable, by itself.

Things get more interesting when you combine these 3 elements - market, 10 yr yield and volatility direction. Since 2000, a good predictor of 3 month market performance is the combination of declining rates, declining volatility and market direction. When the trailing market rose, with falling rates and volatility, the next 3 months averaged a 1.36% gain. If the the trailing market had fell, like our current situation (lower rates, declining change in volatility, falling market), then the next 3 months averaged a loss of 1.43%. Both results are consistent since 1962, the future 3 month returns after a declining market, with declining rates and fall in volatility, significantly underperform those after a rising market.

I guess not until the confirmation of a rising market does the support of lower discounted earnings and declining uncertainty kick in. One other discouraging finding  occurred  when I looked at the absolute level of volatility. Despite falling rates and volatility, if the trailing annualized standard deviation of daily returns was higher than the long term average of 12% (currently north of 22%) the following 3 months were even lower, a loss of 2.50%. So, just because volatility might decline a bit, such a high level of uncertainty implies still plenty of fear, and thus selling pressure.

Just get ready to jump into the market once it has a monthly rise with this rate/volatility environment. Lower rates were the most powerful boost to future stock returns.

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