Dealing with Sudden Market Regime Change

The realized return of different strategies and asset classes changes dramatically over time. Targeting these varying risk premia promises great opportunity – adjusting portfolio leverage at the right time has the potential to enhance profits in good times and curb losses in bad.
The holy grail in investing would be to find ways to pinpoint times that have a high probability to realize above average or below average Sharpe ratios (a measure of risk-adjusted return) for different assets and strategies and adjust exposure accordingly.
I concentrate a lot of my efforts in portfolio management in determining the right level of leverage for each asset class and strategy to fit my risk / return goals in prevailing market conditions. I think a lot of value can be found in this area – especially in combination with the diversification benefits of asset allocation and strategy selection.

Two warning signals
The financial news is constantly bombarding investors with stories and indications trying to predict the future of asset prices – at the moment the possible inversion of the US bond yield curve seems to be the favorite recession indicator.
Simplifying this deluge is essential to yield actionable signals for us and I have tried to create a framework to integrate both fundamental and technical analysis in a systematic way in a previous post.
But when I look for warning signals that can be implemented to decisively reduce portfolio exposure across all my strategies as well as asset classes and individual securities at signs of danger, it boils down to two simple core measures for me:

  1. A long-term moving average of price measures the health and trend in different markets: at the violation of the 275-day moving average I reduce exposure to that particular asset.
  2. The inversion of the VIX Futures Term Structure is a more sensitive signal that has proven to be extremely effective in the past. My rule of thumb is: when the “normal” contango of the term structure (the longer the time to expiration, the more expensive VIX futures are) turns negative by more than -1,5% ( shows the contango percentage – I simply use the first number in the column „% contango“ and make sure the first VIX futures contract has more than 5 days to expiration left) I reduce portfolio exposure at least by half to compensate for the rise in volatility.
    This usually happens every couple of months and most of the time things stabilize within a couple of days and I ramp up exposure again (this caution is necessary, because I use leverage in my portfolio). But sometimes a real market dislocation is signaled (eg. August 21st 2015 or February 2nd 2018) as will the advent of lasting bear market conditions. The strength and length of the inversion hint at the contagion across markets the volatility regime change is likely to cause.

The problem is that, as I experienced in a recent drawdown during shifting market regimes, you have to be quick and flexible at the right time and patient at all others, avoiding over-activity and mistakes.
As many market participants implement related ideas, their adjusting exposure according to volatility has the potential to increase the strength of future regime shifts. I think, this shows in the feedback loop of low volatility causing lower volatility in 2017 as well as the speed and magnitude of the volatility regime change in February 2018, when many market participants were forced to reduce their positions simultaneously.
We have to take this into account and be prepared to act fast to stay ahead of the curve, much like a skier in front of an avalanche. As small investors with access to vast amounts of information, we have an advantage in our ability to completely change all our positions within seconds whereas an institutional risk parity fund, for example, may take weeks to significantly adjust its portfolio.
Not doing anything most of the time is a challenge: long periods of inactivity are interspersed by rare moments where sudden action is required. We have to be able to rapidly adjust our mindset to a real change in the environment after getting lulled by long periods of quiet market action. It is easy to fall into the trap of taking this normality for granted just before it suddenly does change and we are caught sitting on our hands.

Analyzing actual changes in the market regime in 2018
With many major equity markets back to or close to new highs we may be near the end of the recent correction – whether the bull market will continue, melt up or top out from here is, of course, an open question.
Because the correction starting in February 2018 had very pronounced, but quite typical characteristics it is well suited to analyze the effect of sudden market regime change on a portfolio. Sequential dislocations affected different markets at different times, but overall this happened across the board – with trade war rhetoric as the most common catalyst.
These effects are magnified in a leveraged portfolio, such as the one I run.

Let’s have a look at what happened in the market to give us a course of action for future corrections, keeping in mind that eventually one of these will turn into a prolonged bear market.

These are the market regime changes that occurred as I see it:
  • Throughout 2017 equity markets were in a strong up-trend with abnormally low volatility.
  • On Monday, February 5th we saw a sudden regime switch to an extremely volatile sideways market consistently trading above the long term up-trend (200-day moving average).
  • The sideways market continued over several months with volatility falling to average volatility lows (around VIX 12 – 13) through intermediate spikes, that were less pronounced each time: a slow compression to a low volatility sideways market.
  • Beginning in April an upward bias began to re-establish itself in US equity markets. After several consecutive higher highs and higher lows we slowly moved to a low volatility up-trending market regime, with US small caps and tech stocks quickly posting new highs.
  • While the US equity markets held their ground, international markets dropped to new lows in June and are still in correction territory. Most commodities witnessed extreme choppiness as did many currencies and bonds to a lesser degree.

And these are the main turning points where taking action would have been a realistic, repeatable possibility as events unfolded:
  • On Monday, February 5th 2018 we saw the most extreme jump in volatility since the VIX was introduced: VIX up 115.6% for the day.
  • A volatility regime change was actually signaled the Friday before (February 2nd) by the inversion of the VIX Futures Term Structure – this is very important as this early warning sign gave us a theoretical possibility to make portfolio adjustments before the main events even began. We can act on this indication, if we are quick and willing to change our mindset.
  • Subsequently the VIX Futures Term Structure showed three consecutive whipsaw signals, but the short volatility strategies in my portfolio took advantage of the following volatility compression and recovered their whipsaw losses within two months.
  • The strong and repeated warning signals flashed by the VIX Futures Term Structure pointed to a longer lasting regime change. Patiently observing the market behavior at reduced leverage would have been the best course of action. Portfolio volatility continued to stay elevated which led to bad decisions for me, because I failed to keep exposure reduced long enough. Interestingly the real drawdown didn’t happen in my portfolio until June, when I was convinced I had mastered the dislocations. I even introduced a new strategy that went against previously formed investment beliefs and introduced harmful behavior.
  • The S&P 500 retraced all the way to the 200/275-daily moving averages on February 9th, April 2nd and in the beginning of May. These were all good entry points with a high reward-to-risk ratio .

Volatility – taking the pulse of investors
Volatility is a powerful tool one can use in high-level portfolio construction as well as market timing in individual asset classes all the way down to designing and allocating to medium- and short-term trading strategies. It is directly connected to investor sentiment and gives high probability indications to possible investor behavior.
The VIX gauges fear in the market and scared investors behave differently from calm or complacent ones. The VIX Futures Term Structure adds a time component and acts as a barometer of investors´ future expectations – as such it is my favorite risk-on / risk-off indicator across markets and strategies.
The tendency of volatility to cluster has been studied academically and – together with the value and momentum anomalies – is one of the strongest indications that market timing has potential merit.
The historical superiority of risk parity strategies over market beta points to diversification benefits that can be gained from introducing volatility measures to our investment process. If one postulates that expected long-term Sharpe ratios across asset classes are the same, mean-variance optimization leads to a risk parity portfolio.
The popularity of volatility based tools further strengthens these qualities: trend-following, risk parity, short volatility and other strategies all react to changes in volatility. This re-enforces volatility spikes and liquidity spirals causing insecurity that often holds for an extended period of time – a predictable feedback loop leads to exaggerated spikes as well as to extended periods of suppressed volatility – both give us potential edges for profitable trading strategies using volatility as a regime indicator.

Simplification – What continues to work best?
Recent events once again showed me the importance of keeping things simple and mistakes small. To re-balance my basic portfolio allocation I regularly review the performance statistics of the main portfolio strategies I run.

  1. Global Asset Allocation: over-weighting developed markets ex-US and emerging markets contributed to a substantial drawdown of around 15%. Since this allocation was according to value and momentum rules, the result was due to bad luck – part of the risk we take. Several positions were stopped out causing a reduction in allocation.
  2. Trend-following Managed Futures: the best historic diversifier for severe market dislocations failed to outperform in this correction. Trade war rhetoric led to correlated whipsaw losses across markets, but from inception (December 2017) the overall performance of the strategy is good at an annualized 11% return. I count on the strategy to deliver the bulk of my portfolio return in a future bear market through its ability to go short as easily as long.
  3. Short Volatility continues to be my best performer. The built in protection mechanism has worked very well and clear exit rules led to virtually no mistakes in execution. Despite the crash risk the strategy inherently has (it essentially insures catastrophic risks) and losses caused by several whipsawing entry and exit signals in the first half of 2018, the nimble exits led to the smallest drawdown of all strategies. Elevated premia in the wake of the volatility shock caused a quick recovery to new strategy equity highs in less than two months while my other strategies are still under water. This stresses the importance of simple and clear exit signals that one actually manages to follow – it works well for me to have a very risky strategy (paired with high return expectations) and to be able to diligently implement strict exit criteria, because it is dangerous and there is no room for complacency.

Here are my main take aways:
Overall the existence of a written investment plan and good record keeping did help to reduce mistakes considerably (the year-to-date portfolio return is positive at 6% – outperforming all major stock markets), but volatility and drawdown throughout my portfolio was still much larger than necessary.
From the importance of adhering to warning signals to reduce leverage, it conversely follows that in low volatility, up-trending markets the portfolios equity exposure (including volatility as it is closely correlated) will usually generate the bulk of its performance across strategies – aided by carefully selected trending assets. Exposure should be maximized in good times to efficiently harvest temporarily elevated risk premia across asset classes, volatility, trend and carry – while staying ready to adjust exposure at any time.

Once again the boring stuff – sticking to the basics – worked best when my warning signals show green:
  • Be long and levered (through short put options) up-trending asset classes without attempting any fancy short-term predictions.
  • Be short volatility in a simple way: constantly short VIX Futures across expirations.
  • Follow trends with futures by concentrating on the most obviously trending markets and strongly stressing the carry (roll yield) that can be earned among those.
  • Don´t introduce new strategies or strategy adjustments unless they add real value.
  • Have a plan for every position and let your profits run as well as cut your losses as planed – even knowing this mantra by heart I still catch myself doing the opposite rather too frequently.

Good execution is difficult – it takes at least as much effort to stick to a plan as coming up with it in the first place.