TimingCube - Volatility creates opportunity - Nasdaq Volatility Index VXN, CBOE Volatility Index for the S&P 500 VIX, illiquid ETFs, risk of low liquidity ETFs

Current Signal Performance as of

Signal Type	Trade Date	Index	Return since issued
		Nasdaq 100
		Russell 2000
		S&P 500

Market Update

Stocks continued their march higher this week, despite a rebound in oil prices. The Dow Jones Industrial Average briefly surpassed its closing all-time high of 11,722.98 before pulling back slightly while the S&P 500 finished at its highest weekly close since 2001. The major averages moved higher the first four days of the week on renewed optimism that inflationary pressures are under control and that the economy, while clearly slowing down, is not about to collapse and is still strong enough to allow Corporate America to keep growing profits over the next quarters. This was illustrated by the Friday release of the Chicago Purchasing Managers Index (PMI) for September: it came in at a better-than-expected 62.1, its best reading of the year, trumping last week's disappointment from a weak Philadelphia Fed index. The Fed's favored inflation indicator, the core PCE deflator, was also released Friday: it rose just 0.2% in August, confirming that inflation is leveling off. Despite the positive news, the major averages moved slightly lower Friday on reduced volume, as investors locked in profits following a strong performance for the week and the entire month of September.

The Nasdaq 100 and S&P 500 respectively gained 1.96% and 1.60% on the week. For its part, The Russell 2000 closed 0.98% higher. All three indexes still rest above both their respective 50-day and 200-day exponential moving averages (EMAs). There is no change as far as our Model is concerned and our Buy signal remains active.

Trend Timing School

Volatility creates opportunity

Volatility has traditionally been used as a risk indicator, and in an ideal world every investor would prefer their investments to simply go up steadily with no volatility. There are a few issues with this commonly held perception of volatility and risk, starting with the fact that an investment which goes down steadily sports the same exact low volatility and risk as the one going up. Of course the main flaw with such wishful thinking is that the stock market will never oblige and go straight up. If you are a buy and hold investor you now have a problem, which is that during down markets you lose money. Being variously risk adverse you then gravitate towards investments with lower volatility, because they decline less during down markets. Trouble is that low volatility investments are also the ones which gain the least during rallies.

What causes volatility is the age old battle between fear and greed. Sometimes the investing masses get all excited about a particular area, as best seen during manias, and they drive that security or market into excessive extremes. Volatility is greatly exacerbated in illiquid markets. Note that, as explained in the FAQ of the Week below, it is limited supply which drives volatility wild, not low volume.

As Trend Timers we accept the fact that markets will continue to alternate between up and down trends, and we use models and techniques to help keep us on the right side of the market (the majority of the time...). We want to participate in all meaningful up moves and avoid, or benefit from, the larger corrections and bear markets. If you believe in the soundness of trend following principles, then you can start looking at volatility as your friend. The larger the volatility, the larger the amplitude of the price movements, both on the up side and the down side, which in turn translates into more opportunities to achieve superior returns.

There are two key aspects to achieving higher returns with a trend following approach (besides needing a trend): direction and amplitude. For direction we have tools and measures to gage how well correlated a given index or investment is with the broad market trend and the signal, topics which are frequently discussed in these pages. We have previously looked at volatility as a trend or turning point indicator in "Volatility as a market trend indicator" and "Turning points", but today we want to focus our attention on amplitude, which is how large the up and down movements are, and which can be expressed as volatility.

The volatility of various markets evolves constantly, with indexes taking turns in leading the charge. A good illustration of how volatility can change over time by factors of almost an order of magnitude is the Nasdaq Composite as measured by the CBOE Nasdaq Volatility Index - VXN, plotted for the last decade in Chart 1 below. From the high and choppy volatility experienced during the tech bubble, both the inflation and deflation part of it, the indicator has since become tame at substantially lower levels. Not surprisingly, even with a Long and Short strategy, returns have come down correspondingly in recent years. As further evidence of the importance of volatility, the Russell 2000 index which underperformed during the Nasdaq heydays has shown higher returns and volatility in recent years.

Chart 1: Nasdaq volatility history

The weakness of the VXN is that it is an index specific measure. Yes, there is the CBOE Volatility Index for the S&P 500 - VIX, but the choices end there. In order to analyze other indexes we can use the traditional standard deviation measure.

We introduced the nitty gritty of standard deviation calculations in "Risk and volatility" but luckily nowadays you do not have to be a statistician and do all the dirty work yourself. In this article we provide you with a snapshot of standard deviation of monthly returns for the most recent 12 months for many indexes (see Table 1), but there are numerous other sources for standard deviation, for example as an indicator on Stockcharts.com.

Table 1: Standard deviation of monthly returns over the last 12 months
Index (Yahoo! Finance ticker)	Description	Standard Deviation
^BSESN	India	7.3%
^BVSP	Brazil	6.9%
^KS11	South Korea	6.2%
^MXX	Mexico	5.7%
^N225	Japan	5.4%
^ATX	Austria	5.0%
^TWII	Taiwan	4.6%
^OMXSPI	Sweden	4.3%
^RUT	Russell 2000	4.0%
^HSI	Hong Kong	3.9%
^NDX	NASDAQ 100	3.8%
^MIBTEL	Italy	3.6%
^GSPTSE	Canada	3.6%
^STI	Singapore	3.6%
^IXIC	Nasdaq Composite	3.5%
^IBEX	Spain	3.4%
^GDAXI	Germany	3.2%
^FCHI	France	3.2%
^BFX	Belgium	3.2%
^AORD	Australia	3.1%
^MID	S&P 400	3.0%
^SSMI	Switzerland	2.9%
^FTSE	UK	2.6%
^DWC	Dow Jones Wilshire 5000	2.1%
^GSPC	S&P 500	1.8%
^KLSE	Malaysia	1.8%
^DJI	Dow Jones Industrials	1.5%

As we said earlier, the correlation factor plays a significant role as well, but the fact that market indexes with the highest volatility readings tend to be the ones with the best performance remains. And yes, they are also the ones with largest risk and drawdowns.

FAQ of the Week

Question: Is it risky to use illiquid ETFs?

Investors are trained to equate low liquidity with risk, and with most investments you have indeed to worry about finding a buyer when the time comes to sell, and maybe having to lower your price significantly in order to find that buyer. With the steady flow of new ETF choices such as the new breed of short and leveraged ETFs announced earlier this year (see "What is an UltraShort ETF?" and "What are ProShares ETFs?") as well as a raft of specialized geographic and sector funds, there is no shortage of small thinly traded investments. To put things in perspective we can use the industry yardstick QQQQ, a behemoth of over $17 billion in assets which commonly trades over 100 million shares per day, versus the newcomers with market caps of a few hundreds of millions of dollars and daily volumes of a few hundred thousand shares.

Thanks to the way open-ended index ETFs work, the risk is not nearly as high as one would expect with other investments. Instead of a fixed number of shares to go around between buyers and sellers, in the case of ETFs the so-called market makers create and redeem shares in function of market demand. They assemble ETF shares from the shares of the companies in the index it tracks. Thus the price of the ETF is primarily set by the price of the companies in the underlying index and the liquidity is really that of the liquidity of the underlying companies as well. The bottom line is that the main impact of low liquidity is on the spread, the difference between bid and ask prices. For high volume shares like QQQQ the spread is nearly non-existent whereas for illiquid shares it can amount to a few cents.

A more serious consequence of low liquidity is that you will not be able to short most of the newer ETFs, because your broker will not have any in inventory to loan you.

Warm wishes and until next week.

The TimingCube Staff

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