Category: Portfolio Management

Fastest Bull Chases Fastest Bear

Fastest Bull Chases Fastest Bear

Posted on by David Merkel

23 trading days from bull market peak to bear market bottom. 12 trading days from bear market bottom to the start of the new bull market. Both are records.

As I have often said. “Weird begets weird.” When things are weird, it may not be prudent to rely on prior statistical measures. It might be better to think about the structural economy and try to reason about what is going on.

As for me, I am tracking the leading cause of the weirdness — COVID-19, and trying to get a grasp on when the new cases will be minimal.

Things are going better than the politicians are saying. That is why the market has been rallying.

It may take 6-12 months for the economy to return to normal, assuming that the government does its job well with respect to its restrictions.

All that said, it will be volatile. After all,one thing that is utterly new is that the economy would be voluntarily shut down. There were better ways to do this, and there will be many arguments as the actions of governments are debated after this crisis.

It Doesn’t Get Much Better Than This?

Posted on by David Merkel

Photo Credit: Valerie || Photo taken from the coast of Key West at sunset. Relaxing and peaceful, so they say…

Image Credit: Aleph Blog

What an amazing three days. I’ve said to some of my clients that moves of this magnitude are highly unusual. How unusual?

The returns of the last three days would rank sixth in the top ten three-day moves upward for the S&P 500 since 1928. When did the rest of the top ten take place? During the Great Depression — four in 1932, three in 1933, and one each in 1931 and 1935.

Given the overall difficulties of the stock market in the Great Depression, one could say that the 2020 stock market should find being peers with which to keep company.

One more note about March 26th, 2020, that sets it apart: It’s the only one of the dates that may be a bounce up from a bear market low. The fastest bear market may become the fastest bull market if the S&P 500 closes above 2685 soon.

It Doesn’t Get Much Worse Than This?

Image Credit: Aleph Blog

Consider monthly price volatility. Using 21 days to represent a month, the standard deviations of price movements for March 26th would be the eleventh highest. When did the other ten take place. One day after another for ten trading days starting on November 14th, and ending on the 27th of the same month.

Do you feel like the current market action has slugged you hard? I do. That would be a normal feeling, as we haven’t been through anything quite like this in our lifetimes.

Even if you look at implied volatility, for which we only have data since 1986 (if you are looking at the old VIX, 21-day average volatility would have ranked 54th. 39 trading days starting on October 27th, 2008, and 14 trading days starting on November 3rd, 1987 ranked higher. Still it been fascinating to not see the VIX move down much over the last three days. Perhaps there are a lot of investors still aggressively buying puts and calls.

Four Interesting Periods in the Stock Market

So think about:

  1. The Great Depression
  2. Black Monday and related problems in 1987
  3. The Great Financial Crisis in 2008, and
  4. Now

The two “Greats” had collapses in asset prices and corresponding impairments of banks, and some other financial institutions. They were for practical purposes universal panics.

1987 was shocking, but it came back fast, and it didn’t have much collateral damage. The current time period? Well, banks are lending to creditworthy borrowers, and March is a record for US dollar denominated investment grade corporate bonds, Jon Lonski reported at Moody’s in his report released tonight. There’s no lack of liquidity to the big guys with normal balance sheets.

For CLOs, MLPs, repos and Mortgage REITs, that’s different. They are highly dependent on capital market conditions to do well. They are “fair weather” vehicles. In this situation, the Fed is extending itself in ways that it doesn’t need to, and for areas that should be left alone. Nonbanks should not be an interest of the Fed. If you’re going to take all systematic risk away from business, they’re going to behave in even more aggressive ways, and create an even bigger crisis. This one would have been small enough for the private sector to handle, once the initial wave furor over COVID-19 dies away in a couple of weeks.

Same for the Treasury. We don’t need the stimulus, and recessions help to clear out bad allocations of capital. This is a waste of the declining creditworthiness of the US Treasury, which will find itself challenged by a bigger crisis in 10-15 years, with no flexibility to deal with it.

Two Final Notes

I have a series of four articles called, “Goes down double-speed.” The market going down rapidly is less unusual than it going up rapidly. Typically the speed of down moves is twice as fast as up moves. For the current up moves to be so fast is astounding. I would say that it shouldn’t persist, but I think the market will be higher because the first wave of COVID-19 will fade.

And so I go back to one of my sayings: “Weird begets weird.” Weird things happen in clumps, in bunches. Much of it is driven by bad monetary and fiscal policies, including policies the encourage people and institutions to take on too much debt. Unusual factors include COVID-19 and the policy response to it. Part of it is cultural — we take too much risk as a culture, which works fabulously in the bull phase of the cycle, and horribly in the bear phase.

And thus I would say… prepare for more weird. Like COVID-19, it’s contagious.

Estimating Future Stock Returns, December 2019 Update

Posted on by David Merkel

Graphic Credit: Aleph Blog, natch… same for the rest of the graphs here. Data is from the Federal Reserve and Jeremy Siegel

Here’s my once a quarter update. If you owned the S&P 500 at the end of 2019, it was priced to give you a return of 2.26%/year over the next 10 years. That said, the market has changed a lot in the last 2.6 months –as of the close of business on March 18th the market was priced to give you a return of 7.28%/year over the next 10 years. Finally, you have a chance to double your money over the next ten years, while a 10-year Treasury would give you 1.5%/year over the same horizon. To match the expected returns on stocks at this point in bonds, you would have to invest in junk debt, but junk typically doesn’t go longer than 10 years, and who knows what the defaults will be over the next two years?

Now, actual returns from similar levels have varied quite a bit in the past, so don’t take the 7.28%/year as a guarantee. WIth a 2%/year dividend yield, price returns have ranged from -0.95%/year to 6.89%/year, with most scenarios being near the high end.

At the end of 2019, valuations were higher than any other time in the past 75 years, excluding late 1964, and the dot-com bubble. It is not surprising there was a bear market coming. Because “there was no alternative” to stocks, though, it took an odd external event or two (COVID-19, oil price war) to kick bullish investors into bear mode. This was not a supply and demand issue in the primary markets. This was a shift in estimates of investors regarding the short-term effects of the two problems extended to a much longer time horizon.

Two more graphs, and then some commentary on portfolio management. First, the graph on the channel the market travels in, subject to normal conditions:

This graph shows how the model estimates the price level of the S&P 500. It is most accurate at the present, because the model works off of total returns, not just the price level. The gap between the red and blue lines is mostly the effect of the present value of future dividends, which are reflected in the red line and not the blue.

The maximum and minimum lines have hindsight bias baked into them, but it gives you a visual idea of how high the market was at any given point in time — note the logarithmic scale though. If you are in the middle using linear distance, you are a little closer to the bottom than the top.

And finally, that’s how well the model fits on a total return basis. Aside from the early years, it’s pretty tight. The regression explains more than 88% of the total variation in returns.

Implications for Asset Allocation

If you haven’t read it, take a look at my article from yesterday. I am usually pretty disciplined about rebalancing, but this bear market I waited a while, and created two schedules for my stock and balanced fund products to adjust my cash and bond versus stock levels. I decided that I would bring my cash levels to normal if the market is priced to give its historical return, i.e. 9.5%/year over the next ten years. That would be around 2100 on the S&P 500. Then I would go to maximum stock when the market is offering a 16%/year return, which is around 1300 on the S&P 500.

The trouble is this is psychologically tough to do when the market is falling rapidly. I am doing it, but when I rebalance at the end of the day I sometimes wonder if I am throwing my money into the void. Remember, I am the largest investor in my strategies, and if my ideas don’t work, I will lose clients, so this is not an idle matter for me. I’m doing my best, though my call on the market was better during the first decade of the 2000s, not the second decade.

In the process, I bought back RGA at prices at which I love to have it, and have been reinvesting in many of the companies I own at some really nice levels… but for now, things keep going down. That’s the challenge.

In summary, we have better levels to invest at today. Stocks offer better returns, but aren’t screaming cheap. Some stocks look dirt cheap. Most people are scared at the speed of the recent fall. I view my job as always doing my best for clients, and that means buying as the market falls. I will keep doing that, but I have already lost a few clients as a result of doing that, even though I tell them in advance that I will do that. So, I will soldier on and do my best.

Full disclosure: long RGA for clients and me

The Rules, Part LXV

Posted on by David Merkel

Photo Credit: vldd || Relative to a complete bridge, what’s the value of a bridge that will never be completed?

Here’s number 65 in this irregular series:

The second-best plan that you can execute is better than the best plan that you can’t execute.

Rule LXV

It takes more than the right ideas to be an investor. It also takes the courage to make the hard decisions at the time when it hurts to do so.

Will you make more money if you allocate at least 80% of your assets to stocks and other risk assets? Yes. How will you hold on during a gut-wrenching bear market that gives you the feeling that you are losing everything?

You could just refuse to look at your statements, or listen to financial media. But most people will bump into that randomly during a bear market, because the level of chatter goes up so much. It may be better to take a second-best solution and reduce the portion of risky assets to 50-60%, and simply sleep better at night. Reduce until you won’t be nervous, and preferably, make this adjustment during the bull market.

Do you have a nifty trading strategy that you are tempted to overrule because it generates trades that you think don’t make sense, or come at times that seem too painful? Perhaps you need to abandon the strategy, or lower the size of the trades done. Maybe do half of what the strategy would tell you to do.

If you use the Kelly Criterion to size your trades, and the volatility drives you nuts, maybe size your trades to “half Kelly.”

Am I offering an opiate for underachievement? Well, no… maybe… yes… Look, personalities are not fixed, much as some say that they cannot change. If you have sufficient motivation, you can come up with ways to change your personality to be able to deal with more risk, or, conclude that you will do better if you take less risk.

Writing out a set of rules can useful, as is testing them to make sure they actually work. In general fewer rules are better.

An example of this in my life was when I was a corporate bond manager, I made an effort to forget prior prices of a bond, thus forcing me to be forward-looking in my management. When I was younger, I told myself that there would be losses, and they were a price of getting the gains on average.

But if you can’t make your personality change, then you have to adapt your investment strategy to let you be happy while still achieving most of your goals. As an example, if you like to sell stocks short, it would be wise to have some sort of limit as to how much you are willing to lose before closing out a trade — this applies more to shorting, as losses are unlimited as prices rise, but gains are capped.

Ordinarily, if a person or institution is close to even-keeled with respect to risk, the time horizon and uncertainty of the cash flows from the assets should be the main criteria for asset allocation. But when a person is overly timid or bold, that will become the dominant criterion for their asset allocation.

It is important not to be of two minds here. Admit your weaknesses, and either fix them, or live with them. The trouble comes when you think you are strong, but then give in when a bad event happens that was beyond your capacity to handle.

It’s also important to understand that the market can be more vicious than at any prior point in history. Yes, there are historical highs and lows for every variable — but both can be exceeded… the speed of the current bear market is an excellent reminder of that. Try to understand that there will be as Donald Rumsfeld once said “unknown unknowns.” Have you left enough slack in your strategy for some really bad scenarios? Have you considered that it’s not impossible to have a second Great Depression event, despite the best efforts of politicians, regulators and economists? Have you considered that it is possible to eclipse the valuation highs achieved in 2000?

And consider the phrase from my disclaimer “The market always has a new way to make a fool out of you.” Have you considered what scenario would be poison for what you currently do? Unlikely as it may be, can you live with that scenario? If not, scale down your strategy until you can live with it. Or, figure out what your coping strategy would be.

The first life insurer that I worked for had the strategy that if things went wrong with their investing, they would sell policies more aggressively and invest the proceeds to grow their way out of the problem. They ended up being the largest life insurance insolvency of the 1980s, as their worst case scenario arrived, and their capital was depleted. They would have done better to grow more slowly, and more soundly. The same would apply to Enron and other companies that try to grow too fast. This is another case where the second best is achievable, but the “best” is not.

So, know yourself, and know the markets well. Leave some slack in your strategy… don’t play it to or past the absolute maximum that you can handle. Have some humility, and live in reality. For most investors, that will pay off in a big way.

The S-Curve, Once More, with Feeling

Posted on by David Merkel

Photo Credit: Lars Plougmann || Indeed, this seems like a race, and the S-Curve is a major challenge to drive through

This will be brief, because I am still working on it, but it is my weak conviction that as far as the markets are concerned, the COVID crisis will largely be over by next Friday. How certain am I? Not very — I give it a probability value of around 30%.

If my thesis is correct, reported new cases of COVID-19 in the US will peak by Friday of this week, and will be 90% complete by next Friday. I will be watching how many new cases are reported. New cases tend to peak when total cases increase at a mid-teens percentage rate over the prior day. Because reporting is noisy, you don’t see that so easily, but the inverse logistic curves I am estimating are consistent on that figure for all the countries I have modeled so far.

I’ve run models for South Korea and Italy as well, and I’ll run them for a few more countries tomorrow. They are all pretty consistent with each other. Italy’s new cases should peak tomorrow, if they haven’t already.

I know everything is dark and gloomy now. Even if my modeling is wrong, which is a significant likelihood (I am extrapolating), I find it difficult to believe that we will still be in crisis mode by tax day.

So, cheer up. The number of COVID-19 cases is unlikely to be overwhelming, and we are all likely to survive this. The markets will revive, though maybe not energy stocks for six months. Those are a separate issue.

And if new cases track my estimates, I will put more money into the market. That’s all for now.

SImilarities of the Coronavirus to 9-11

Posted on by David Merkel

Photo Credit: Gene Han || This picture was taken four years after the attack.

I am going to reprint here the beginning of the article The Education of a Corporate Bond Manager, Part VI. I am doing this because it describes how our investment department dealt with 9-11. Here it is:

After 9/11, and and before the merger was complete on 9/30/2001, our investment team got together and came to an unusual conclusion ? 9/11 would have little independent impact on the credit markets, so be willing to take credit risk where it is not well-understood by the market.? We bought bonds in hotels, airplane EETCs (A-tranches), anything having to do with confidence in the system at that time.? I consciously downgraded our portfolio two full notches from September to November.

I went to a Chief Investment Officers’ conference for insurance investors in October 2001.? What I remember most is that we were the only company being so aggressive.? In a closed-door meeting, the representative from Conseco told me I was irresponsible.? To hear that from a company near bankruptcy rang the bell.? I was convinced we were on the right track.

By mid-November, we had almost completed our purchases of yieldy assets, when I received a phone call from the chief actuary of our client expressing concern over the credit risks we were taking; the rating agencies were threatening a downgrade.

Well, what do you know?!? The company that did not understand the meaning of the word risk finally gets it , and happily, at the right time.? We were done with our trade.

We looked like doofuses for three months before the market began to turn, and I began a humongous ?up in credit? trade as we began to make a lot of money.? By the time I was done in early June, I had upgraded the whole portfolio three full notches.? A great trade?? You bet, and more.? What?s worse, it was what the client wanted, but not what it should have wanted.

The Education of a Corporate Bond Manager, Part VI

9-11 was a shock to the system, but one where our investment team concluded that everything would return to normal, and relatively soon. We thought that the terrorists had gotten lucky, and that there was no persistent threat. Thus, prosperity would return, well, as long as the economy would hold up, which was in question at that time. The second-order effects of the deflation of the dot-com bubble were more severe than 9-11 would ever be.

From October 2001 through October 2002, our department bravely soldiered on, and during that time I played the speculation cycle relatively well, as noted in other episodes of “Education of a Corporate Bond Manager.”

The main challenge was trying to separate the transitory from the medium-term from the permanent. 9-11 was transitory. Deflation of the dot-com bubble was medium-term, and general prosperity was the long term — and definitely so at the valuations experienced in October 2002.

The same is true today. The coronavirus, no matter how ugly it will be, is transitory, as are the effects on the supply chain, travel, etc. But if you can believe it, valuations are still absolutely high (5.5%/year over the next 10 years), though not high relative compared to bonds and cash.

So, if you have courage, buy the damaged industries. People will still travel, and not a lot of people will die. Buy the strongest companies that you know will survive.

My main point to you is this: the coronavirus is transitory. Act as if it is so, and think about what the economy will be like 3-5 years from now. Do that, and you will likely prosper, unless the effects of too much debt finally comes to bear on the market. We can’t tell when the day of reckoning will come on that topic.

There Is Always Enough Time To Panic, Redux

Posted on by David Merkel

Photo Credit: Gopal Vijayaraghavan || A stampede of wildebeest! Panic! Panic! MIndless panic!

Before I get started, dare I mention that Aleph Blog is a teenager now? 13 years old. Who knew it would last this long? Maybe it will outlast TheStreet.com where I got my start in business and investment writing.

Looking back at some of the posts from February and March of 2007, I find it interesting to see at least two posts about panicking. I think there were more.

The market was not as highly valued as it is now, but had structural deficiencies in the finance sector, which we don’t have now. Debt levels at nonfinancial firms were lower than what we have now, but for the most part, investment grade corporations have laddered their debt, and interest rates are indeed low, leaving ratios like EBITDA/Interest usually in good condition.

The main event at that point in 2007 was a sharp move down in the Shanghai stock market that gave many the jitters. Like the coronavirus, the effects on the markets are indirect, and not likely to be long lasting.

But what other similarities and differences are there? In early 2007, the Fed was tightening, en route to overtightening. Today, they are probably more likely to loosen than to stand pat, but they won’t tell you that openly now.

Areas of debt that are troublesome — margin debt, student loans, low end consumer credit, nonfinancial junk-rated corporate bonds and loans, and sovereign debts. Each of these have grown rapidly, while credit related to the housing markets is in decent shape.

Six business days ago, my estimate of future stock returns over the next ten years was 2.21%/year, the lowest I have ever seen it (and a new all-time high for the stock market). Today it is 4.40%/year. Quite a move. Also in the quite a move department is the 10-year Treasury note, whose yield went from 1.56% to 1.23%, a new all-time low.

Six business days ago, I would rather have owned investment grade corporates versus stocks. That has flipped. For some of my clients, near the end of the day, I did some small buying, moving from 79% stock to 81%. Nothing major, just some rebalancing trades.

I said two weeks ago: “As such, lighten up on risk assets, and prepare for the next drop in the stock market.” Now I don’t deserve any credit for that statement… I’ve been saying it for too long.

That said, the second-best strategy that you have the courage to follow is better than the best strategy that you are too scared to follow. As for me, if the market keeps falling, I will be buying *very slowly.* But if the current drop has you scared, well, maybe sell down to a level where you sleep well at night. I think mixes of risky assets to safe assets of between 80/20 and 50/50 are suitable for almost everyone, unless you are saving for a short-term need.

Best to do risk control when the market is not jumpy, slumpy, lumpy, or bumpy. Tell you what, if you are worried now, if the market retraces half the loss, take something off the table, and sleep well at night.

That said, there are no guarantees. Now is the only time you can act. Act wisely.

What Makes An Asset Safe?

Posted on by David Merkel

Photo Credit: acciarini ||Sometimes a good conversation elucidates a matter…

Q: What defines a safe asset?

A: My, but that is a broad question. Do you have something more specific that you are trying to answer?

Q: Well, I’ve heard that the wealthy often invest their excess assets in real estate. It seems perfect. As Twain said, “Buy land, they aren’t making any more of it.” It provides income, and protects against inflation.

A: Do you own the land free and clear, or did you have to borrow to own it?

Q: I don’t own any land, aside from my house, and yes, I have a mortgage there. Why are you asking this?

A: Do you remember the financial crisis 2008-2011?

Q: Yes, but why does that matter?

A: Many people had paid a lot for their homes, and were stretched in making mortgage payments. Then one of the Ds hit.

Q: Ds?

A: As written by one wordy blogger:

3) As housing prices fall, which they should because housing is in oversupply, more homeowners find themselves in trouble.  Remember, defaults occur because a property is underwater, and one of the five Ds hits:

  • Divorce
  • Disability
  • Death
  • Disaster
  • Dismissed from employment

Q: My, but he is a piece of work. So, houses aren’t a safe asset?

A: Well, most of the time they are, particularly if don’t have any debt on them. But there are situations where housing prices have been bid up to where the prices don’t justify the cash flows if you are borrowing to own it and are renting it out.

Q: What do you mean?

A: No asset’s price can survive if the implicit net rent is negative. I.e., if you have to feed the property to hold it.

Q: Huh?

A: Imagine that instead of living in your home, you borrowed money to buy the house, and have rented it out. What I am saying is that when those that do this are losing money, the price of the house is too high. They are relying on price appreciation to bail them out, and no one can control that.

Q: Is there a simpler way to say this?

A: When you have to give up money to hold onto an asset, you are in a weak position, and it means you should sell, particularly if many people are having to do the same thing. Properly priced assets produce cash; they don’t consume cash. If on net it is cheaper to rent than borrow and own, then it is probably better to rent.

Q: Are you just saying that risk is a function of the price of the asset? An overpriced asset is risky, and an underpriced asset is not?

A: I am saying that, but there is more to say as well. An asset could be priced below its fair market value, and it could still be risky if it is misfinanced. Take for example the insurance company General American back in August 1999.

Q: Huh?

A: Old news, I know, and most people don’t follow insurers. But they had written a lot of floating rate GICs terminable at par in 7 days if they got a ratings downgrade. What was safe if it had only been 5% of their assets became toxic at 25% of their assets. The amount they were selling ballooned because money market funds could treat the assets as short-term paper.

Once the downgrade came, there was no way to raise that much money so fast. They ended up selling out to MetLife for 50% of their net worth. MetLife picked up control of one of their subsidiaries, RGA, in the process. They made exceptionally good money on that purchase.

It’s like crossing a stream that is 3 feet deep on average, but there is a spot in the middle that is 20 feet deep. If you can’t swim, don’t cross it.

Q: I heard you wrote to Cramer about General American at the time.

A: Yes, that was my first email to him, and I explained the situation in such detail that he republished the email for readers. That was my introduction to Cramer.

Q: So, you are saying there are two things to safety — price and financing?

A: That’s all I’ve said so far, but there are a few other things. The character of management matters. Remember my piece, Dead as a Severed Horse?s Head?

Q: Oh, the zinc miner that sided with the bondholders against the shareholders?

A: Exactly. With better management, they could have skated through the troubles, and perhaps sold the company to a larger base metals miner like BHP.

Q: Is any of this similar to the losses you took on Scottish Re or National Atlantic?

A: Yes. I thought you were my friend, though.

Q: Well, I read your confession pieces on both of them.

A: It still hurts, but faithful are the wounds of a friend.

Q: Proverbs 27:6, I like it.

A: I still remember the stress and the losses.

Q: Then is that all? Price, leverage, and management?

A: Pretty much. There are some secondary matters to those who do not want to do the hard work. Companies that pay dividends and buy back stock are shareholder friendly, and that is good so long as they don’t borrow too much to do that.

Also, there are the issues of operating leverage — companies with low fixed costs are safer. But that’s about it, unless you want to talk about investments other than stocks.

Q: Can we take this up later?

A: Sure, let’s take this up in part 2.

Focus on the Long-term

Posted on by David Merkel

Photo Credit: Sacha Chua || Planning is a good thing.

In any investment decisions, one must look at the long term. Don’t pay any attention to news that does not permanently change business conditions.

The thing that drew my attention here is the rather weak coronavirus. Stalin supposedly said, “A single death is a tragedy; a million deaths is a statistic.” My sympathies to the families of those who have died from the coronavirus. But to society as a whole, the coronavirus has done less damage than influenza does every year.

As such, I don’t pay attention to the coronavirus. Stocks are long-term assets, and if the coronavirus will have no impact on the economy past 2025, I don’t see why I need to pay attention to it.

The same applies to politics. Is there someone coming like Chavez or Maduro who will radically reshape business/industry? No? Well, don’t worry so much. Money votes for itself. Few genuinely want to slay the processes that make society well-off in aggregate, even if they are getting a lesser portion of the increase.

In healthy societies, there is a tendency to protect property rights. Property rights are an aspect of human rights, let the liberals note this. We can argue about the edges of the rights, but fundamentally property rights must be protected, or society falls apart.

Now, at present, I am not a bull on the stock markets, but it is not because of any event risk, but rather high valuations. We aren’t at the same valuations that we experienced at the top of the dot-com bubble, but we are in the range of valuations that only existed from 1998-2000. At present the S&P 500 is expecting gains of just 2.24%/year over the next ten years.

Even this is not the long term. Okay, bad returns for ten years, and after that, back to historic norms. Fine, that’s right. But how many will panic in the process of a crash, and not hang on for the long-term?

I think it is worth edging asset allocations toward caution as valuations are so high. We can’t predict when the disaster will happen, but when it does, there will be better opportunities to deploy free cash.

As such, lighten up on risk assets, and prepare for the next drop in the stock market.

Avoid Short Volatility Products

Posted on by David Merkel

Photo Credit: Niccol? Ubalducci || Tornados are similar to financial events where volatility erupts. You can predict them in aggregate, but not in specific

Remember when I wrote Where Money Goes to Die? Well, short volatility products cratered, but cryptocurrencies treaded water, with a lot of volatility.

I am telling you today to avoid short volatility products again. This seems to be a case where people don’t learn. Why? Because there is seemingly free yield from shorting volatility in the bull phase of the equity market. The opposite side of the trade is a disaster as well…. indicating that timing has to be precise if you are trying to earn money off of rising volatility.

Here is an additional reason to avoid short volatility products: the stock market is priced to produce a return of 2.5%/year over the next 10 years. The only time that has been lower than that is during the dot-com bubble.

In this situation, with valuations so high, it would not take much of a scare to make the market drop sharply, which would make volatility jump. Many short volatility products would be wiped out.

So, if you own short volatility products, sell them now. I am not saying “buy long volatility products” because that is a gambler’s game. It is a time to protect principal, not a time to seek speculative gains.

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