Understanding the Market Volatility ... 12/2/2019 thru 3/2/2020

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Paula, a Research Analyst with a Master's in Public Health, is interviewing for a Senior Health Care Analyst position. Here is the simulation of the first interview, leading to the final interview.

Interviewer: Paula, since this is a general interview to narrow our choices down to the final ten, it is designed to test candidate's knowledge of the basis data analysis and modeling, rather than the health care data universe per se.

Paula: Sounds very reasonable.   

Question # 1
Interviewer: Lately, the stock market has been going through some serious turbulence so we decided to use the current market data as the basis for this general interview. Does the High/Low Ratio ("Hi/Low") proxy the VIX in this example?

Paula: Yes, it does. A high correlation coefficient of 0.88 confirms that they have been more or less moving in tandem. For example, when the Hi/Low jumped from 101.79% to 115.08%, the VIX also jumped from 17.08 to 40.11. They have a high positive correlation, meaning they move in the same direction.

Question # 2
Interviewer: So, are these two volatility metrics -- Hi/Low ratio and VIX -- interchangeable? If so, is there any need for the Hi/Low ratio? 

Paula: The two metrics are not inter-changeable. The Hi/Low ratio is a descriptive metric that helps analyze the past activity but does not project anything about the future sentiments of the market, whereas the VIX is computed in a more forward-looking manner to project out the short-term future sentiments of the market so they, in a way, complement each other.

Question # 3
Interviewer: In this example, 10 out of the 14 weeks, VIX remained within a tight range of 12.10 to 15.47. How come the average is 18.04?

Paula: Average is heavily influenced by the outliers. The two outlier data points of 40.11 and 41.94 are weighing in, pulling the average up. If you had used the median, it would be around 14, not 18.

Interviewer: Let me quickly check what the median would be. Yes, it's 13.85. Great mental math!

Question # 4
Interviewer: Using your logic of median, if we re-compute all components, what changes would we expect to see?

Paula: The impact of the two lower outlier data points of High, Low and Close would be minimized, thus pushing their median values up. On the contrary, the impact of the two unusually high outlier data points of Volume and Hi/Low would be significantly lessened, thus pushing their median values down.

Question # 5
Interviewer: Is there any other market component that demonstrates a similar relationship with the VIX?

Paula: Yes, the Volume component. In fact, VIX and Volume show even a higher correlation of 0.90. Case in point: When the Volume spiked from 1.096B to 3.019B, VIX jumped from 17.08 to 40.11, proving how they move almost in lockstep.

Question # 6
Interviewer: In terms of Volume, does anything else stand out?

Paula: Yes, the two traditionally-low Volume weeks of 12/23 and 12/30. If you compare the Volume of 12/23 with that of 2/24, you see a huge change -- in fact, a factor of 4.5. Of course, it's an aberration, not a norm.

Question # 7
Interviewer: Why did it happen?

Paula: It's strictly news-driven. The news pertaining to the outbreak of Coronavirus has been making the financial markets around the world very nervous. The uncertainty surrounding this outbreak has a prolonged impact. The financial community needs to have more clarity about this breakout before a real sense of calm returns to the market.    

Question # 8
Interviewer: You seem to think that the many unanswered questions about this outbreak are impacting the market. Please name one such unanswered question that is plaguing the healthcare industry. 

Paula: We do not know who will pay for the tests and possible hospitalizations for the millions that are uninsured. Even the millions that are insured with high deductibles are very nervous. For instance, my mom is self-employed so she pays for her own insurance, but to keep the premium manageable, she opted for a plan with a high deductible which is making her very nervous now.

Question # 9
Interviewer: Why do you think the Low and the Closing prices ("Close") have near-perfect positive correlation?

Paula: When the market has been trending down, Low and Close go more or less hand in hand. The flip-side is equally true -- simple collinearity!

Interviewer: Congrats, Paula! You have moved on to the final round. Any questions?

Paula: Thank you very much. If I get this job, do I get to report to you directly? Actually, I would love to be on your team.

Interviewer: I would love to have you on my team, too!

- Sid Som, MBA, MIM
sidsom1@gmail.com

The Final Interview

Link to the Book

Did Russell 2000 Outperform S&P 500 in 2019?

        Intended for New Graduates

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Emily, a new graduate with co-concentrations (Econ & Finance), is interviewing for Equity Analyst position. 

Question # 1
Interviewer: Explain to us the basic difference between these two indices. 

Emily: While the S&P 500 index measures the performance of 500 large-cap stocks, the Russell 2000 index measures the performance of 2000 small-cap stocks. S&P 500 is the most widely followed stock market index.

Question # 2
Interviewer: Is there a market definition of large-cap stock? Also, can you name a few large caps?

Emily: Typically, a large-cap company has a market value of at least $10 Billion. Microsoft, Apple, Amazon, Google and Facebook are examples of large-caps. 

Question # 3
Interviewer: Can S&P 500 include one such large-cap stock that is listed on Nikkei only?

Emily: No. S&P 500 comprises large-cap stocks that are listed on US Exchanges.     

Question # 4
Interviewer: The data table shows S&P 500 has higher volatility than Russell's. What "quick" metric did we use to arrive at these volatility figures? And why?

Emily: I believe the quick metric you used is the Coefficient of Variation (commonly known by its short form COV). COV is the ratio of standard deviation to mean. Since you are making inter-index comparisons, you used the "normalized" metric. 

Question # 5
Interviewer: By glossing over these two graphs, do you notice any similarity?

Emily: Yes, between August and December, they both produced linear growth. Spectacular growth, indeed!

Question # 6
Interviewer: Any striking dissimilarity, per se?

Emily: Yes, the correction in August was way more pronounced for Russell than that of S&P's. 

Question # 7
Interviewer: By looking at the data table, can you tell us how S&P outperformed Russell in terms of overall growth?

Emily: Because S&P produced 8% growth between January and August, whereas Russell remained on a slippery slope, failing to hang on to its gains. 

Question # 8
Interviewer: To take advantage of these indices, what investment vehicles would you recommend to our clients?

Emily: Index Funds, Index ETFs, S&P Futures and Options, etc.

Question # 9
Interviewer: Of these two indices, which one would you recommend to our conservative clients? Or, would you recommend both?

Emily: Russell 2000 would not be appropriate for them.

Good Luck!

-Sid Som, MBA, MIM
President, Homequant
homequant@gmail.com

                     Link to the Book

FAANG – Review of 2019 Performance

** Intended for New Graduates **

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Wendy, a new college graduate with a major in Economics, is interviewing for the Market Analyst position.

Question # 1
Interviewer: Do you know what the acronym 'FAANG' stands for?

Wendy: Yes, it refers to five major stocks: Facebook, Amazon, Apple, Netflix and Google. In fact, I follow all of them very closely.

Question # 2
Interviewer: Okay, now take a look at the FAANG table and give us your interpretation of its overall performance.

Wendy: Obviously, Apple has hugely outperformed the other four components. While Facebook and Google produced fairly good returns, they were nonetheless below the S&P 500's 2019 return of 30%. Unfortunately, Amazon's return was sub-par while Netflix disappointed its investors. 

Question # 3
Interviewer: Why do you think we've added the Coefficient of Variation (COV)?

Wendy: COV is a very common metric used to demonstrate the volatility of asset classes and components. Amazon was the least volatile component while Apple was the most volatile in the FAANG complex.  

Question # 4
Interviewer: By simply glossing over the data series, would you have known that Apple was the most volatile in the complex?

Wendy: Yes, by simply looking at the data series I could have found it out. It has a much wider spread in the series than the rest, resulting in the highest COV and the volatility.


Question # 5
Interviewer: Was that the right use of the COV metric?

Wendy: It's perfectly fine in an interview setting. If I were compiling a report for a client, I would go back to the daily closing data, at least the weekly closing.

Question # 6
Interviewer: Okay, now switch to the Apple vs. Facebook chart and compare and contrast their performances. 

Wendy: They moved more or less in tandem during the first half of the year. Since then they produced significantly different performances. While Apple continued on a linear  growth path, Facebook moved sideways, remaining mostly range bound.

Question # 7
Interviewer: In terms of the market behavior, do you notice any similarity or dissimilarity between Amazon and Google?

Wendy: Yes, very dissimilar behavior. During the first half of the year, Amazon produced a nice run-up, while Google continued to decline. They however reversed courses in the second half.

Question # 8
Interviewer: Now let's move on to the Amazon chart. What is the point of overlaying the 2-month moving average trendline?

Wendy: To introduce a level of smoothing. It smooths out the noises that are inherent in month-over-month data series. For instance, the moving average trendline here is proving that the April and May data points are somewhat aberrations.   

Questions # 9
Interviewer: How would you graph all five components into one graph?

Wendy: By showing the month-over-month +/- growth rates, so they are apples-to-apples. 

-Sid Som, MBA, MIM
President, Homequant, Inc.
homequant@gmail.com

Link to the Book

How did Dow Jones Industrial Average (DJIA) Fare in 2019?

** Intended for New Graduates **

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Jason is interviewing for Senior Research Analyst with a major brokerage house.

Interviewer
Question # 1: How would you interpret the 2019 DJIA trend?

Jason: Visually, it's a linear trend. It has been trending at 45 degree. 

Interviewer
Question # 2: When you say 'Visually,' do you mean there could be a better technical trend?

Jason: Yes, a polynomial trend would show better fit with significantly higher r-squared. Yet, I would stick to the linear trend as it would be easier to explain to the general clientele.  

Interviewer
Question # 3: What is the missing piece between these two graphs? Or, is there one?

Jason: Volatility. While the Weekly one depicts the market volatility, the Monthly one irons it out. 

Interviewer
Question # 4: Is there another way to depict the market volatility? If so, would that make the volatility case any stronger?

Jason: The Daily closing graph will show higher volatility but it won't make a better case than the Weekly one. As you know, a level of smoothing -- which the Weekly one incorporates -- is a better way to present volatility to the general clientele. 

Interviewer
Question # 5: What market event is common in these two graphs?

Jason: The precipitous market drop in May, bringing Dow under 25,000. Of course, by early July, Dow climbed to a new high, crossing the 27,000 mark. 

Interviewer
Question # 6: Do you think the May correction was driven by basic fundamentals of the market?

Jason: No. It was more news driven like trade, tariffs, etc. than pure market fundamentals. 

Interviewer
Question # 7: How did you come to the conclusion that it was news-driven rather than fundamentals-driven?

Jason: Had it been fundamentals driven, the correction would have lasted much longer. Instead, you can see the immediate V-shaped recovery leading to new market highs.

Interviewer
Question # 8: What is the difference between the 2-period and 3-period moving averages in the above graphs?

Jason: The 3-period in the Weekly graph points to 3-week moving average, whereas the 2-period in the Monthly refers to 2-month moving average.

Interviewer
Question # 9: Would you advise your clients to continue to pour in money in Dow in Q1-2020? 

Jason: Selectively. I will continue to recommend the Dow components with high dividend payouts. I will also urge them to keep some cash handy, just in case a correction occurs, leading to good buying opportunities.

-Sid Som, MBA, MIM
President, Homequant, Inc.
Homequant@Gmail.com

Link to the Book

The Missing Link between Fundamental and Technical Equity Analysis

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The missing link between the fundamental and technical equity analysis is a market-based statistical Correlation Matrix.

Analysis of the above Correlation Matrix

1. The correlation among Apple (AAPL), Amazon (AMZN), Facebook (FB) and Google (GOOG) is very (positively) high (> 0.80), meaning they will move in tandem. A portfolio comprising exclusively of such highly correlated stocks would be considered an 'Ultra Aggressive' portfolio.

2. Twitter (TWTR) however adds a low-to-moderate positive correlation to the aforesaid four, meaning there are days TWTR will not necessarily move in lockstep with the other four stocks. A portfolio constructed as such would, nonetheless, be 'Very Aggressive.'

3. IBM, on the other hand, shows negative correlations with all five and obviously very high negative correlations with the first four, thus providing an excellent hedge. The inclusion of the IBM hedge would lower the overall risk, paving the way for an 'Aggressive' portfolio.

Ideally, in order to capture any meaningful shifts in relationships, researchers should run this matrix in three phases: short-term (recent 30 days), medium-term (6 months) and long-term (9-12 months). 

Disclaimer - The author is not advocating any of the stocks listed here; instead, this is just a research piece  - often overlooked - connecting fundamental and technical analyses. Consult your Registered Rep, RIA or Financial Planner for an appropriate asset allocation model and the holdings therein.  

-Sid Som, MBA, MIM
President, Homequant, Inc.
homequant@gmail.com
  

Link to the Book

Can Dow Jones Industrial Average (DJIA) Predict the Housing Market and vice versa?

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Suraj, a Harvard graduate with two years of experience as market strategist, is interviewing for Senior Quantitative Strategist.

Question # 1

Interviewer: Would you consider these two market segments predictive of each other?

Suraj: Absolutely. The Correlation Coefficient and Regression R-squared are showing they move in lockstep and in the same direction.

Question # 2

Interviewer: Is the linear trendline the best fit? Eyeball the scatter and use your best quantitative judgment.

Suraj: For a management presentation, the linear trendline is fine. For a technical presentation, I would use Polynomial trendline with 3rd order which would reduce the noise on the outer end of the curve.

Question # 3

Interviewer: By doing so, how much improvement do you expect to see? 

Suraj: I would expect the R-squared to move up in the vicinity of 0.96.

Interviewer: Okay, please give me a minute and let me find out. Yes, you are right. It's 0.956, so it's actually 0.96 rounded. I must say, you have developed an excellent eye for the data distribution.

Question # 4

Interviewer: Let's assume we are trying to hang our hat on this solution. Would you recommend this to our clients who enjoy short-term trading?

Suraj: No. This analysis is developed off the monthly data so it is not viable for the short-term traders. For the short-term housing traders, the analysis must be based off the local home sales data and for the short-term equity traders, it must be developed off the most recent 3-months of daily closing data or most recent 6-months of weekly closing data.  

Question # 5

Interviewer: Agreed, this is an analysis, not a solution. Either way, who would you recommend this analysis to? 

Suraj: Those who have much longer time horizon, like the Mutual and Pension Fund Managers, and other long-term investors.  

Question # 6

Interviewer: How would you improve upon this analysis in a very short period of time?

Suraj: I would try to study and isolate the seasonality in both data. For example, for the residential investors, Q1 might be better than Q3. Likewise, Q3 might be the best quarter to sell stocks to book profit. Analysis of seasonality is part and parcel of any long-term trend analysis.  

Question # 7

Interviewer: Would you stick to this data and time series to study the seasonality?

Suraj: No. The study of seasonality requires at least one full cycle of data, preferably more, so I would go back a few more years. Of course, this is a large enough sample to study the basic collinearity so I would expect the collinearity would still remain in the ballpark.

Question # 8

Interviewer: Don't you think the impact of new economic and fiscal policies and other major economic events would distort the seasonality analysis?

Suraj: No. Those impacts can be separated out. For instance, the new cap on SALT has been impacting the high-end residential market in high tax areas so the co-mingling of that sort of data would be imprudent. 

Question # 9

Interviewer: How would you (physically) separate out that data? Give me examples from both data series.

Suraj: In terms of the housing data, you are using the Case-Shiller Composite 20, meaning the largest 20 MSAs in the country. We know the pockets hit hardest by the SALT cap so they must be removed from the data. Similarly, I would not use the stretch of Dow Jones data post 9/11.     

  

* Case Shiller is a registered trademark of S&P CoreLogic.

-Sid Som, MBA, MIM
President, Homequant, Inc.

homequant@gmail.com

Link to the Book

Consider these Additional Factors while Choosing High Dividend Stocks - for Long Haul

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In choosing a set of high dividend stocks for the long haul, data savvy investors need to additionally consider, at a minimum, price-earnings ratio and volatility. Of course, equity research analysts would consider a slew of other factors including book, cash, reserve, growth, liquidity, debt, etc.  

A composite combining PE and Beta (or V-factor) is critical. The two composites - Beta-adj and Vfact-adj - have been used (the graphic above) to make the case. While the Beta-adj composite points to Verizon (VZ), P & G (PG), IBM (IBM Corp.), XOM (Exxon Mobil), GE and JNJ (J & J) as the best (< 50 as acceptable scale value) high dividend stocks, Vfact-adj picks PG, VZ, XOM, IBM and MRK (Merck). 

Despite high dividend yields, CVX (Chevron) and KO (Coca Cola) didn't make either cut due to high PEs. Likewise, BA (Boeing) didn't fare well either due to the high volatility.

Disclaimer - The author is not advocating any of the stocks listed here; instead, this is promoted as an alternative research in creating a statistically significant and more predictive volatility factor for individual stocks. Consult your Registered Rep, RIA or Financial Planner for an appropriate asset allocation model and the suitability of stocks and other holdings.  

-Sid Som, MBA, MIM
President, Homequant, Inc.

homequant@gmail.com

Link to the Book