2022 was a very painful year in my investment career, nearly nothing seemed to work. I used to rely a lot in rotating positions in between asset classes that were typically uncorrelated but… not 2022. Nearly everything was correlated and moving south. I take investment decisions based on different volatility parameters like the VIX roll yield and VIX measured at different time frames but… 2022 was special: nothing flashing red while the equity market slowly and painfully moving down. In the middle of the year, I asked myself:
It took me a few months, lot of Excel and a tip from a market veteran to get into a Eureka moment. This friend of mine said: 2022 reminded him of the Dotcom bubble. At that time the market was trending down but, at a certain extent, there was neither panic nor noise, just a painful bleeding. He was right. If we assume that panic and noise translate into VIX spikes, in Figure 1, it can be observed that despite a 20-30% drawdown, the VIX was elevated but never shoot significantly higher than 30% during the Dotcom bubble. This was very different from what many of us have experienced after the 2007-2009 financial crisis. We got into the mental picture of: there is a lot of drawdown thus the VIX will have to spike. As 2022 showed, this was far from the truth.
Figure 1: S&P500 drawdown and VIX
In essence VIX is a standard deviation. A value of 15% means that within one year from now, the S&P500 could close plus/minus 15% within 68% probability. First keyword is “plus/minus”. We should disconnect the believe that the S&P500 movement is inversely correlated to the one of the VIX. This is correct 85% of the time, meaning that there are 15% of instances in which the two are positive correlated or uncorrelated. From Figure 1, we can make a second observation: the VIX spikes only during uncertainties. An example quite fresh to our memory is March 2020. There are other case like 2018 Q4 and August 2015. This gives an answer to the first question, we should stop assuming a nearly perfect inverse correlation between the VIX and the S&P500.
Could this situation have been spotted?
I have tried not to overcomplicate my life and I made the hypothesis that somehow this information was hidden in the prices of the main US indexes. What 2000 and 2022 had in common? In both instances, everyone was talking about stock market bubble. Usually overinflated prices are found in growth stocks (typically part of the Nasdaq 100) and less in value stocks (typically part of the Dow Jones). This can be observed in Figure 2, there was a major divergence between the growth of the Nasdaq and Dow in 2000 and 2022.
Figure 2: Price evolution of the Dow Jones and Nasdaq 100 during the Dotcom bubble and 2022.
But the market is not the economy, even if a bubble exists we do not know when it is going to burst, maybe until now. I will not share the details of my secret sauce, but by looking at the price action of the Nasdaq and the Dow Jones, it is possible to derive an indicator that spots when a bubble might burst. In Figure 3, this “bubble burst” indicator showed high readings during 2000, 2022 and early 2023.
Figure 3: S&P500 drawdown and bubble burst indicator.
The simplest way to use it, it is to identify a threshold level beyond which a strategy moves from 100% equities (S&P500 in this example) to cash. I found the sweet spot being 75-80%. Higher reading indicates pain for the equity market. A simple backtest is shown in Figure 4; a threshold value of 80% was used. The lower chart shows a drawdown that is drastically reduced. The reduction in drawdown resulted in 85% higher return (upper chart) just with the use of one single indicator.
Figure 4: Return (upper chart) and drawdown (lower chart) of the S&P500 buying and holding vs. going to cash above the threshold value of the bubble burst indicator.
We are almost in 2024, why am I writing this article now? History often rhymes and it is not unlikely that we will experience again a stock market bubble burst, better being prepared. Think about 2023: most of the gains in the equity market were driven by the AI mania. AI stocks are just a few, all the others stayed relatively flat throughout the year.
At the moment of writing, my bubble burst indicator is well above 80%. Better being prepared and having a plan of what might come!
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