Market Beat: Looking at regime change
TRUCKEE, Calif. andamp;#8212; No, Iandamp;#8217;m not discussing political leadership changes in a foreign country due to intervention or a coup. The term andamp;#8220;regime changeandamp;#8221; also applies to the stock market.The stock market goes through regime changes or shifts. What the term refers to is the state of the market in terms of its trend and volatility. The majority of the time, the market trends quietly upward with low volatility. These periods of low volatility are interrupted by brief periods of rapidly falling prices and high volatility.Without delving into the underlying mathematics of the econometric models that calculate regime change, it can be summed up in simple terms to mean that about 85 percent of the time the market will trend higher with low volatility. Weandamp;#8217;ll call this andamp;#8220;state one.andamp;#8221; About 15 percent of the time the market will be in andamp;#8220;state twoandamp;#8221; characterized by falling prices with high volatility. The trend is approximately three times as large in the negative direction when the market is in state two. Also, when the market is in state two, it tends to revert to state one quickly with 90 percent probability.OK, so what does this type of quantitative research mean to investors? What it means is if you invest in the market you should expect most of the time to see your portfolio increasing in value with modest price swings, but also expect to have those quiet periods interrupted by brief periods of rapidly falling prices with larger price swings.Long-term investors can use the periods of falling prices to add to market positions. Investors with a shorter time horizon, like those who are already retired, can find the state two periods to be very unsettling. Investors can always consider using some sort of hedging mechanism if the volatility is causing too many sleepless nights. Index options can be used to hedge downside risk as can some of the new volatility and inverse ETFs.As the market heads into third quarter earnings season, positive news should bring higher prices and a decline in the volatility. In the event that corporate earnings are poor and we see more bad news from the Euro zone, the heightened volatility could be with us awhile longer.Kenneth Roberts, a Truckee-based Registered Investment Advisor, has been in the securities business since 1992, has worked as a branch manager for a major Wall Street firm and is currently a portfolio manager for Fusion Asset Management. Information on his money management service can be found at http://www.fusiontargetretirement.com or by calling 775-675-8065. Past performance does not guarantee future results. Consult your financial adviser before purchasing any security.
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