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Vix Asset Allocation Model

For several years now, I am been writing posts explaining my Vix Asset Allocation Model. I thought that it would be helpful to summarize that Model in an Instablog Post here at SeekingAlpha. I will be summarizing more lengthy discussions contained in my blog, with some liberal drag and drops mostly from the following posts.

Vix Asset Allocation Model Explained Simply

Use of the VIX as a Timing Model

VIX Chart from 2007: Alerts and Triggers Major Disruption of Cyclical Stable Bull VIX Pattern-August 2007 Trigger Event

VIX and S & P Compared 1990 to 1997

Vix Charts from 2004 2005 2006 Stable VIX Patterns Phase 1 and Phase 2

Parallels to VXO 1987-1988

This model is based on historical patterns and is obvious once an investor opens a long term VIX Chart and knows the stock market history between 1990 and now: VOLATILITY S&P 500 Index Chart

There are two Main Patterns:

1. Stable Vix Pattern: Continuous Movement in the Vix below 20, an investable bull market in stocks.

2. Unstable Vix Pattern: A Whipsaw Pattern Movement in the VIX at levels above 20, a far more riskier market for the individual investor, most likely what most people would call a bear market, or a Transition Phase from a bull to a bear market.

Each Main Pattern is divided into Two Phases:

Phase 1 STABLE VIX PATTERN: Mostly moving in a range from 15 to 20

Phase 2 STABLE VIX PATTERN: Mostly moving in a range of 10 to 15

Phase 1 Unstable Vix Pattern: Whipsaw Movement in the VIX mostly in the 20 to 30 range with temporary movements below 20 and above 30, mostly descriptive of an ongoing bear market with periodic rallies, and also descriptive of a Transition Phase from Bull to Bear.

Phase 2 Unstable Vix Pattern: Catastrophic Bear Market marked by a decisive break in a Phase 1 movement by a major burst into the 40s followed by even more elevated levels in the VIX.

Alert: An "Alert" happens when either an unusual break in a pre-existing pattern occurs, or there is some meandering by the VIX above a level considered to be significant under the model, without a decisive break into a bull or bear pattern characteristic of the Transition Phase or an unstable VIX pattern. An example of an alert is the decisive break in the Phase 2 bull market pattern in the VIX in 2/07. (see typical story from February 2007: Bloomberg The break was not a trigger event since the pattern broken was a stable bull market pattern Phase 2, and the Phase 1 pattern was still stable. An alert, however, should cause an investor to learn everything possible about the external events causing the alerts and to be considering possible major changes in asset allocation.

A Trigger Event Ushers in the Unstable Vix Pattern: A "Trigger" is a decisive break in the stable bull market pattern by a spike in volatility clearly outside the range tolerable for a Stable VIX pattern. Those spikes happened in two stages in 2007, in August and November. The trigger event requires a change in exposure to stocks. Timing of that change can vary, but LB (my Left Brain) has noted under all models covering the entire time period for which there is a volatility index that there would have been at least one, usually two, counter-moves back to below 20 that would be accompanied by a rise in the market average. This would afford an opportunity to lighten up at better prices than prevalent during the TRIGGER EVENT Phase. While this opportunity has happened in the past, there is certainly no guarantee that it will happen after the next Trigger Event or any other ones in the future.

Trigger Events:

April 1987 based on volatility index for the S & P 100 (VIX data starts in 1990): Parallels to VXO 1987-1988

October 1997: More on VIX AND ASSET ALLOCATION

August 2007: VIX Chart from 2007: Alerts and Triggers Major Disruption of Cyclical Stable Bull VIX Pattern

There have been three prior Trigger Events (data from Yahoo Finance):

August 2007 Trigger Event (multiple confirmations November 2007; January 2008; March 2008)
Aug 21, 2007 25.25
Aug 20, 2007 26.33
Aug 17, 2007 29.99
Aug 16, 2007 30.83
Aug 15, 2007 30.67
Aug 14, 2007 27.68
Aug 13, 2007 26.57
Aug 10, 2007 28.04
Aug 9, 2007 24.46

1987 Trigger Event (based on volatility for S & P 100-VXO-VIX Data Starts in 1990)

May 4 27.18
May 1 28.22
Ap 30 28.45
Ap 29 29.22
Ap 28 31.2
Ap 27 31.46
Ap 23 29.13
Ap 22 27.95
Ap 21 27.22
Ap 20 27.18
Ap 16 27.48
Ap 15 27.59
Ap 14 28.97

October 1997 Trigger Event (not resolved until later part of 2003, confirmed in October 1998)

Dec 30, 1997 24.38
Dec 29, 1997 26.79
Dec 26, 1997 29.27
Dec 24, 1997 30.27
Dec 23, 1997 29.86
Dec 22, 1997 28.56
Dec 19, 1997 29.18
Dec 18, 1997 27.19
Dec 17, 1997 26.33
Dec 16, 1997 26.11
Dec 15, 1997 27.37
Dec 12, 1997 27.92
Dec 11, 1997 27.63
Dec 10, 1997 24.55
Dec 9, 1997 23.36
Dec 8, 1997 23.22
Dec 5, 1997 22.65
Dec 4, 1997 23.84
Dec 3, 1997 23.92
Dec 2, 1997 25.66
Dec 1, 1997 26.01
Nov 28, 1997 27.43
Nov 26, 1997 28.95
Nov 25, 1997 28.95
Nov 24, 1997 29.80
Nov 21, 1997 26.65
Nov 20, 1997 27.32
Nov 19, 1997 29.93
Nov 18, 1997 31.58
Nov 14, 1997 33.66
Nov 13, 1997 36.64
Nov 12, 1997 37.84
Nov 11, 1997 36.38
Nov 10, 1997 36.63
Nov 7, 1997 36.27
Nov 6, 1997 32.57
Nov 5, 1997 32.18
Nov 4, 1997 32.24
Nov 3, 1997 32.09
Oct 31, 1997 35.09
Oct 30, 1997 38.20
Oct 29, 1997 33.75
Oct 28, 1997 31.22
Oct 27, 1997 31.12
Oct 24, 1997 23.17

The Unstable VIX Pattern is what happens after the Trigger Event. This pattern will be a dangerous and difficult market for the individual to navigate. There will generally be a lot of volatile up and down movement in stocks, with the end result being a long period of going nowhere. Going nowhere on a roller coaster is also the hallmark characteristic of a long term bear market, where the buy and hold investor in an S & P 500 Index would likely lose principal after adjusting for inflation even with dividends reinvested. I started to invest in the late 1960s. The annualized total return (dividends reinvested) of the S & P 500 from January 1966 through July 1982 was -1.813% Adjusted for Inflation and before taxes. That is an annualized loss. Dividends back then were taxed at the highest marginal ordinary income rate.

S&P 500 Return Calculator

The long term bear market can last for 15 or more years. The Vix Model is a shorter term signal and its signals can be given in long term structural bull and bear markets.

Phase 1 of the Unstable VIX Pattern will be market by repetitive movement in the VIX between 20 to 30, with temporary spurts to over 30 and below 20. A potentially more ominous pattern, Phase 2, would be a burst into the 40s that could lead to even further elevation into the 50s and beyond, which would be associated with catastrophic stock market losses similar to what happened after the Lehman failure in September 2008. There was a Phase 2 formation in late September 2008 that gave investors two days warning to get out. SEPTEMBER 2008: FORMATION OF THE DEADLY PHASE 2 OF THE UNSTABLE VIX PATTERN The operative word after a Phase 2 signal is caution.

The Unstable VIX Pattern, Phases 1 and 2, can last for a very long time. The one decision investor could just sit it out in five year treasury notes, rolling them over if necessary, and save themselves a lot of heartburn. Historically, it would be difficult for a skilled trader to navigate the Unstable VIX Pattern to beat the return of a five year treasury note.

The more adventuresome investor, such as myself, will play the volatility with the substantial cash raised after the First Trigger Event. Generally, this will be a mechanical trading strategy. During Phase 1, stocks are sold when the VIX moves below 20 and hedges are bought for the stocks that are kept.

When the VIX spikes toward 30 or over, stocks are bought again and the hedges are sold. This will work until Phase 2 comes around which may never happen. It did happen in September 2008. Then the investor following this path, which included me, would likely have no hedges, having sold them when the VIX spiked to the low 30s or high 20s, and would have added some stock positions back. Then, an adjustment has to be made when it becomes apparent that a Phase 2 of the Unstable VIX Pattern has formed, with the recognition that danger lurks at ever corner.

If I bought good companies when their price had fallen to reasonable levels for a long term holder, I can become a long term holder, start reinvesting the dividends, and potentially buy more shares during this catastrophic phase of the Unstable Vix Pattern with the cash stash. I could then wait for the movement to below 20 in the VIX and then decide what to do with the position added just prior to the Phase 2, Unstable VIX Pattern formation coming out of a long standing Phase 1 pattern. Trading and Asset Allocation in Stable and Unstable VIX Pattern; More on VIX AND ASSET ALLOCATION; Stable and Unstable VIX Patterns Impacting Changes in Allocation to Stocks, Bonds and Cash (November 2008 Post). In the case of my PEP shares, I was able to sell those shares before a significant price drop and then buy them back after the price fell over $20. Volatility, Catastrophic Event Formation, Asset Allocation Decision for Pepsi September 2008

When the catastrophic event formation occurred in September 2008, the Phase 1 Unstable Pattern had been in force since August 2007, and I could trade that pattern based on the movement in the VIX until Phase 2 emerged, and then there is no guidance from the model. The crap has hit the fan.

As shown in great detail in this blog, I carefully deployed cash flow to buy mostly income producing stocks that appeared to present good values during the September 2008 to March 2009 period, and this worked out just fine. It may not the next time. The Great Depression Part Two was avoided by the efforts of governments around the world.

Green Light: During an Unstable VIX Pattern, the VIX will periodically move below 20. A Stable VIX Pattern is not formed until there is continuous movement in the VIX below 20 for 3 months. Some minor movement above 20 is allowed without restarting the count.

Green Light Signals:

May 1991 and Terminated by Trigger Event October 1997: VIX and S & P Compared 1990 to 1997

January 2004 and Terminated by Trigger Event August 2007: More on VIX AND ASSET ALLOCATION

September 2012- Stable Vix Pattern as of 9/26/12

Non-Confirmation Event: The rise in the market is not being confirmed by the movement in the VIX. The most important series of non-confirmation events occurred in 1999, when the VIX meandered at levels inconsistent with a rally in stocks. The model would require selling into non-confirmation events.

TRANSITION PHASE: The formation of an Unstable VIX Pattern out of a Stable VIX Pattern, marked by a Whipsaw Pattern of up to 30 or so on the VIX, followed by a movement down below or near 20, while pundits still view the bull market as ongoing. An example of a Transition Phase would be the start of the Unstable VIX Pattern in August 2007 even though the Bear Market is dated as starting in October 2007. This is sometimes called the Warning Phase.

Basic Premise-Heightened Volatility Whipsawing Up and Down Results in Lower Prices to Compensate for Risk: The basic premise is that increased volatility means increased risk. With increased risk, there comes a significant danger of lower stock prices as a means for the market to compensate and adjust for that increased risk. The Model is basically saying the STABLE VIX Pattern is a bull market, and the Unstable VIX Pattern is a bear market or at a minimum a far more riskier market for the individual investor, particularly one facing situational risk. The Model does not tell an individual what to do or how much to sell after a Trigger Event. That is up to each individual based on their tolerance for risk, ability to manage it, and most importantly their unique situational risks.

Humans do not handle spikes in volatility well. The natural reaction is to flee or to require a lower price to buy stocks in order to compensate for highly volatile movement. Humans need tranquility, calmness, and comfort. Those conditions are met when the VIX moves continuously below 20. Those conditions are not met when the VIX moves out of that stable pattern of relatively low volatility and starts whipsawing up and down at higher levels.

Trading Strategy: During an Unstable VIX Pattern, a buy and hold strategy for stocks is abandoned in favor of a hyper active trading strategy. A constant allocation shift is performed, raising and lowering stock allocation. It is anticipated that the S & P 500 will show no gain after inflation, even with reinvestment of dividends, during the Unstable VIX Period. VIX-Formation of Phase 2, Unstable Vix Pattern (discussing Unstable Period from October 1997 to March 2004).

Use with 200 Day SMA S & P 500 Crossovers: The Model is based on history but was designed by a conservative investor who is now primarily interested in preservation of capital and income generation.

To avoid false signals, I intentionally built in a 3 month requirement of continuous movement below 20 prior to the Model flashing a green light signal.

During the Unstable VIX Pattern period, there will be temporary movement below 20. That is part of the whipsaw pattern up and down pattern.

The VIX moved below 20 in August 2000 and in May 2008 but both movements were temporary. Since the Unstable VIX Pattern was still in force, the movement below 20 needed to be sold rather than bought. This is a link to the May 2008 VIX numbers: VIX Historical Prices

To prevent a purchase during a temporary VIX movement under 20, the three month safety valve was built into the model.

This creates a tension between what I would normally do based on valuation and the Model. As shown in my voluminous posts throughout 2009, I was buying that year, but the VIX Model did not flash a green light signal until September 2012.

Valuations become most attractive for long term purchases during those periodic catastrophic stock market events. I have lived through three of those: 1974, 2000-2002 and 2008-March 2009. I missed the Big One: 1929-1932, but learned a valuable lesson from my Great Uncle Tom who became an investor in 1932. Stocks, Bonds & Politics (April 27, 2009 Post).

A potential timing device to incorporate into the Model would be crossovers of the 200 day SMA line. I would require personally a downside crossover of at least 5%, plus a Trigger Event, to significantly downsize my stock allocation. An upside break in the 200 day SMA line would have gotten the investor back into stocks around late June 2009: S&P 500 Index Chart

As with any other Model, it works until it doesn't. So I always remain flexible and am never a slave to any mechanical buy/sell model. The VIX Asset Allocation Model can be adjusted to fit an investor's own risk profile.