Mitigating volatility

December 29, 2015 09:00 AM

A volatility-mitigating program, developed in 2012 in cooperation with a prominent New York-based asset management firm, uses a preplanned program of staged purchases of securities during sell-offs as both a profit opportunity and to help stabilize markets. 

The primary assumption behind this program is that markets will eventually recover. This strategy has become widely used, even ubiquitous, and has developed its own buzz phrase: Buy on the dips. While this is not necessarily a new idea, nor does it fully encompass the program in question, it broadly describes the practice at hand.

Here, we’ll revisit the results of this program and examine what happened in light of the market performance following the August sell-off.

Value changes

It’s important to realize that markets adjust to conditions and justly change in value, such as in reaction to the impending increase in interest rates long-anticipated by investors.

The inquiry examined the idea of “obsolescence,” that, in some cases, when businesses or trends become obsolete their value justly changes to the downside, so buying on dips cannot result in success. In these cases, a message of “investor beware” would be prudent.

There is the general idea that if a group of rational investors all come to the same conclusion at the same time (to sell a security, for example), there would be no buyers because all would be sellers, which would create a radical drop in price (or no price at all). Luckily, markets are more complex than this, and at any given moment there are typically buyers to meet sellers’ demands—albeit at adjusted prices.

However, as prices fall below comfort levels, buyers may disappear and liquidity can dry up—as happened in the credit crisis of 2008-09—allowing for increasingly greater price declines and leading to the market crash.

With respect to the volatility-mitigating program, it created a counter-weight to this problem by inducing its participants to buy more if the price moves lower—a sort of continual, increasing averaging-down process that’s rewarded on recovery. The “trigger zone” for the strategy is shown in “Volatility-mitigating system” (below).

In the formula shown on the chart, T1 is an initial trigger point that indicates a rapid increase in change in price over time and above a normalized threshold. The T2 level is a secondary trigger point that indicates abnormal or disorderly conditions—as predefined by historical norms—confirmed by an increase in volume (identified by Vt, t+1, t+2…) over time such that it exceeds average daily volumes of a given preceding time. This is confirmed again by an increase in volatility (as measured by the Vix) such that a threshold  VOTH is exceeded and is in a range between a ceiling VOC or high point and the threshold. 
A volatility reading below the threshold and above the floor VOF acts as a non-confirmation of the condition.

The Fed's role

Some markets, particularly fixed-income markets, can lose principal value (despite higher yields) on rate increases by the Federal Reserve. To verify this, simply look back to the rate increases during Paul Volcker’s time as Fed chairman to see that banks incurred tremendous losses as the Fed tried to wring inflation out of the system through excessive increases in rates; the discount rate reached 14% in September of 1981.

To compound the problem, investor dollars seeking security from the turmoil elsewhere went directly into U.S. Treasuries, bypassing the banks altogether. Also note that part of the responsibility of being a primary bank—that is, a member of the Federal Reserve system—is enduring the impact of the rate changes set by the Federal Reserve. In return, bankers can borrow at most-favorable rates: The discount window at the Fed. This risk is perhaps one of the greatest facing bankers.

Until more recently, bankers would grin-and-bear adverse rate hikes. Now, with the growth of the derivative markets and the pressure for risk mitigation, bankers can attempt to hedge away the impact of a rate hike, but this generally has proven to be too costly or impractical for most. In fact, a contributing senior bond manager holding one of the largest portfolios informally commented that it was simply too expensive to hedge away interest rate risk on a larger scale.

So, in the last few days of August 2015—when many were on vacation and perhaps not paying as close attention as warranted—the Dow Jones Industrial Average dropped 11% in four days and had its first 1,000-point intraday move down (see “So much for summer markets,” below). Some say this was a reaction to the situation in China, where equity markets have been experiencing challenges and growing pains for some time. 

This also may be an example where buying on the dips will not immediately be rewarded. This is because there is an actual resetting of asset values based on the anticipation of the cost of money going up. Typically, for example, fixed-income-producing assets will be worth less in a rising-rate environment. Perhaps this is a one-time adjustment or a series of adjustments with no recourse.

However, in the equities markets, happily, and in this case, asset values can once again recover and even potentially exceed prior levels based on increases in earnings that can offset the effect of increased rates. In other words, stocks can outgrow the negative effects of an interest rate increase.

Finding value

Based on this illustration, where might be the best place to allocate funds during a rate hike? Equities markets. Typically, we would want to invest in those securities that act less like bonds (not preferred shares nor convertibles). It also follows that growth stocks might fare better in a rate-hike environment. Staples, too, could do well as dividends are buffered by growth to produce capital appreciation. 

Months ago, and to little fanfare, current Fed Chair Janet Yellen announced a blueprint to “normalize” rates over three years, from less than 1% now to target estimates of around 2.5% to 3% for the discount rate in three years (see “Seeking normalcy,” below). This would be an average of a one-quarter-point increase per quarter. The plan keeps getting pushed back in anticipation of more-suitable economic conditions, but, some experts say that the numbers are already baked into current asset prices, suggesting that sell-off events like those at the end of August 2015 are typical precursors to the move.

Where unique market conditions have prompted a situation of record-low interest rates, we can expect some anomalies during a readjustment period. Some interest-rate-sensitive assets that have fared well during the rate decline, such as fixed income securities, preferred stocks and real estate, may now experience the reciprocal impact of capital declines during rate increases. 

An understanding of this fundamental shift in the market landscape is important for investors and traders who follow any rigid set of rules and triggers for establishing positions. It is certainly relevant today for those who currently maintain a “buy the dips” program. The opportunity for significant gains could present itself in key asset classes during, and immediately following, the Fed’s impending readjustment period for interest rates.

About the Author

Nathan Kay is a senior management consultant with more than 20 years of experience in the financial services industry.