My solution was fairly simple; I measured when the market had become extremely stretched (either up or down) under the premise that when the market reaches extremes, it is prone to sharp, unpredictable, portfolio-busting moves.

A flavor of that filter is included in the State of the Market report and both the YK and Scotty strategies. In all three cases, as the market becomes more “abnormal”, position sizes are reduced (eventually to zero).

This month has given us another opportunity to see the filter in action. The graph below shows the S&P 500 (blue) versus the State of the Market’s abnormal market reading for that day (red) over the last three weeks.

As the market slid into the abyss this month, the filter ratcheted up, hitting a high of 75% on 01/21. The market has stabilized a bit (relatively speaking) over the last couple of days, and the filter has pulled back to the mid-40’s.

Looking at the filter applied to an actual strategy, the graph below shows YK’s performance over this same period both with (red) and without (green) the abnormal market filter. The red line represents actual real-time results, and the green line the original pre-filter version of the strategy.

(logarithmically-scaled)

The first thing that catches the eye is that filtered YK underperformed unfiltered YK. And therein lies the rub with this approach: I think in most instances the filter will reduce total returns.

There is significant money to be made when the market is making big volatile moves, but there is also significant pain inflicted when we’re wrong. It’s really a trading-philosophy decision as to whether we want to embrace or defend against that volatility.

In the case of YK and Scotty, I think we’ve generated enough consistent alpha, that we can leave some positive returns on the table when things get scary.

Note: Readers looking to follow the abnormal market filter can find it everyday in the second box of the State of the Market report (click to zoom).

Happy Trading,
ms