Finding Bottoms

Predicting how equities will move is usually a waste of time. However, every few years we see extreme price declines that are often followed by massive rallies (much like bungee jumping), which are sometimes short-lived bounces (like 2015) and sometimes the beginning of multi-year rallies (like 2011). For investors who have cash to allocate or want to lever up when the odds are favorable, identifying these turning points may be worthwhile. When market declines get going, I monitor to the following categories of indicators to find tradable bottoms.

Implied Volatility

Implied volatility is a rough measure of how much investors are paying for protection. The headline benchmark is the VIX (first chart below), which measures the 30 day implied volatility of the S&P 500 index. We can look at the implied volatility of different time horizons, different indices (or ETFs or individual stocks), and even the volatility of implied volatility (second chart below).

VIX as of 2/28/2020
VVIX as of 2.28.2020

Credit Spreads

Credit spreads are an indication of how much yield investors demand. When markets are calm and perceived risk is low, credit spreads are low. When there is turbulence in markets and perceived risk is high, credit spreads widen. Although most useful in fixed-income markets, credit spreads can used as a rough proxy to evaluate fear in many asset classes.

Corporate Spreads at of 2.28.2020

Oscillators

Many oscillating indicators are based on some combination of price, time, volume, number of securities, and so on. One of the most commonly used oscillators is the Relative Strength Index (RSI) (first chart below). Another popular one is the McClellan Oscillator (second chart below).

RSI (14D) for SPX as of 2.28.2020
McClellan Oscillator as of 2.28.2020

Practical Considerations

I don’t recommend market timing to most investors, but for those who have cash to invest or who don’t mind constantly monitoring the market and taking some risk, below are some practical considerations:

  • Price declines often reverse before some (or even any) indicators hit extreme levels and many indicators may not corroborate one another. Respect the weight of the evidence.
  • Investors may nail the exact bottom every now and then, but it is more common to be a little bit early or a little bit late. It’s okay.
  • Extreme readings do not have to mean revert. I personally like to see big reversals in implied vol, spreads, and prices (!) before buying in size. I may average into positions once extreme levels are reached, but will accelerate purchases after a reversal has gone on for 2-3 days (as I rarely trust a bounce before 1-2 days has gone by).
  • There may not be a V-shaped bounce or recovery. In 2011, the market declined and then bounced around for months before rallying (for years!). Investors should not fixate on a particular scenario, but be prepared for anything.
  • Investors should do their own homework, define their own risk tolerance, and use the tools that work best for them and the environment.

This post is not a commentary on the recent market volatility, but hopefully a reference for this and future selloffs.

The Mexican Fisherman

The famous “Mexican Fisherman” story is at least fifty years old, but it is a timeless tale that is both revealing and enlightening. Below is one version of the story:

An American investment banker was taking a much-needed vacation in a small coastal Mexican village when a small boat with just one fisherman docked. The boat had several large, fresh fish in it.

The investment banker was impressed by the quality of the fish and asked the Mexican how long it took to catch them. The Mexican replied, “Only a little while.” The banker then asked why he didn’t stay out longer and catch more fish?

The Mexican fisherman replied he had enough to support his family’s immediate needs.

The American then asked “But what do you do with the rest of your time?”

The Mexican fisherman replied, “I sleep late, fish a little, play with my children, take siesta with my wife, stroll into the village each evening where I sip wine and play guitar with my amigos: I have a full and busy life, señor.”

The investment banker scoffed, “I am an Ivy League MBA, and I could help you. You could spend more time fishing and with the proceeds buy a bigger boat, and with the proceeds from the bigger boat you could buy several boats until eventually you would have a whole fleet of fishing boats. Instead of selling your catch to the middleman you could sell directly to the processor, eventually opening your own cannery. You could control the product, processing and distribution.”

Then he added, “Of course, you would need to leave this small coastal fishing village and move to Mexico City where you would run your growing enterprise.”

The Mexican fisherman asked, “But señor, how long will this all take?”

To which the American replied, “15–20 years.”

“But what then?” asked the Mexican.

The American laughed and said, “That’s the best part. When the time is right you would announce an IPO and sell your company stock to the public and become very rich. You could make millions.”

“Millions, señor? Then what?”

To which the investment banker replied, “Then you would retire. You could move to a small coastal fishing village where you would sleep late, fish a little, play with your kids, take siesta with your wife, stroll to the village in the evenings where you could sip wine and play your guitar with your amigos.”

(This story was originally written by Heinrich Böll, although Tim Ferriss published the above adapted version which can be found across the internet.)

Parenting 101

“Do you have any financial advice for new parents?”

A handful of friends have asked this question in the past week. The question often relates to childcare expenses or college savings plans, but I usually advise new parents to prioritize the below items before anything else:

  • Buy enough term life insurance to provide for your family if you and/or your spouse die prematurely. There’s no “right” amount, so ask yourself what you would want covered if you passed. Your salary of x years? Your spouse’s salary so he/she wouldn’t have to work for y years? Childcare expenses for z years? Payoff a mortgage? College tuition? Other expenses? Add those numbers up and go get some quotes.
  • Establish an estate plan, including a revocable living trust and will. The will should appoint a guardian for your children if you pass away while they’re still minors, although the courts do have the final say. The will also directs what to do with assets that were excluded from the trust (or forgotten to be put in the trust, which I see very often!). The trust should help avoid probate for assets placed within it and provide for supervision of the assets for the benefit of the children.

Buying insurance and establishing an estate plan are simple steps, but each does require some time and money. Fortunately, each item can be a one-time decision, which is a relief for many new parents who are completely overwhelmed with the chaos of parenthood!

The above is educational and is not legal or financial advice. Every situation is different and I’m not an insurance agent or an attorney.