Legends of the Fall
I always associate the month of September with the beginning of the fall, the start of the school year and playoff baseball. The fall is the time to get serious. The sun-soaked and carefree days of the summer are over, and it is time to roll up the sleeves and work hard. For Wall Street it is when portfolio managers come back from their summer vacations and begin to re-adjust their portfolios going into the last quarter of the year. There have been so many market crashes during the fall that the season has become legendary for having high volatility. Without trying to explain the theory behind this phenomenon, we decided to crunch some numbers to see if the anecdotal evidence was in fact true. We took the median implied volatility using the VIX over the last 20 years by calendar month:As it turns out, the fall has been historically quite volatile but September sticks out as having the highest volatility of any calendar month. Volatility actually tends to decline heading into the end of the year. Whether or not this effect is predictive is a different story, but the numbers suggest that we may have to buckle up our seatbelts this September. As for catalysts for producing higher levels of volatility, look no further than the hotly anticipated Fed meeting on the 20/21st of the month. If the Fed hikes or even suggests that it may be more likely to hike this will cause stocks and bonds to sell off. So what are the odds of an interest rate hike? We always like to look at the CME Fed Watch tool to get a gauge of market implied probabilities:
The odds of a rate hike are currently 24%, which is actually quite low and suggests that the Fed is unlikely to hike rates at the September meeting. Goldman Sachs found that going back to 1994 roughly 90% of rate hikes showed at least a 50% probability within 30 days of the FOMC meeting. This September happens to be especially notable since it precedes the presidential election. Mark Hulbert of MarketWatch found that the Fed has only hike interest rates once prior to a presidential election. Most of the time the Fed stayed put which is consistent with a logical aversion to any political fallout that may arise in either direction. So while the Fed may talk up an interest rate hike prior to the FOMC meeting, it is probably unlikely that they will follow through. This reflects the fact that recent economic data carefully scrutinized by the Fed has been surprisingly soft. To hike rates into this backdrop would be inconsistent with their general approach, and it would certainly shake up the markets.
A lot of wealthy investors have been sitting on the sidelines given uncertainty over the election. From this standpoint it seems that if the Fed manages to hold off on raising interest rates, and Clinton gets elected (the market’s current expectation), that the market may have the dry tinder to stage a large rally this fall. However, what happens in between is anyone’s guess. Like the baseball playoffs in October, you can expect to have plenty of surprises. The probabilities are always changing.
While I can make a logical case for what might happen (like any good discretionary manager), ultimately we will defer to the market. The benefit of being systematic is that you do not have to be “right”, you just need to be right on average or even when you are wrong on average you just need to make more when you are right then you lose when you are wrong. The discipline of being able to change portfolio positions according to the rules is what makes it less likely that you will be really wrong. This happens to discretionary managers when the market goes in the opposite direction of their thesis and they do not change their positions. It is silly to assume that the market is naïve and does not constantly weigh different scenarios or information. After all, the market is the sum of the bets of a lot of very smart people. Instead, paying attention to the changes in the rate hike or election probabilities is what keeps you from going too far off the rails. Since the market tends to discount this information, it makes sense to adjust portfolios as prices change accordingly in order to manage risk effectively.
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