Correlations closed the week at .4 increasing during the last two days of the week with higher realized volatility.
This week, we want to focus on convexity. The easiest way to think about convexity is the ratio of the size and frequency of wins, to the size and frequency and losses. Positive convexity is best described by a trading strategy which has several small losses and few outsized gains.
At trading firms, positive convexity strategies are favored. This reduces risk of ruin and increases probability of longer term success of the firm.
At this particular juncture in the market we believe being long is a strategy that exhibits negative convexity. In that sense we are not certain how far stocks will rally, but believe the downside risk is greater than the upside potential. That is best exhibited by our return distribution chart:
On Thursday our regime switch indicator triggered – meaning vix is high relative to average correlations – a hint that a topping process may have begun.
VIX is high because longer term correlations remain near one. Market participants are skeptical and rightfully so.
Shorter term correlations going towards the lower range of historical data is what could be interpreted as sampling error – which is why we show the entire distribution, correlations across multiple time frames.
We don’t know what happens next, but we think that there is no positive convexity of being long equity risk at this point in time.
Thanks and have a great week.