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Will “Red December” Continue into the New Year?


Every major holiday comes with its classic color scheme.

Every year around Christmas, the world gets merry with sparkling Red and Green hues. Arielle Eckstut, the co-author of Secret Language of Color says, “It solidified in our collective imaginations the Red of Santa’s robes with the Green of fir trees and holly and pointsettia that we already had in our minds. … This particular shade of Red and Green came to signify Christmas.”

However, the hue of Green seems to be missing from the market this December.

In the last 44 years, there were only 11 Decembers or 25% of the time, when the S&P 500 Total Return Index turned Red in the festive month of December, with the maximum hue in December of 2002 with a return of -5.87%. In comparison, the month-to-date return of the index as of December 19, 2018 stood at -9.07%. This December can claim to be the worst December in the last 44 years. Now, there were only 3 (1974, 1981 and 2002) out of 44 years, or only about 7% of the time, when a Red December also brought a negative year for S&P 500. There is still a likelihood…or hope not, that 2018 will be the 4th in the history of 44 years. Does this look blazing? Indeed!

As we all know, the volatility is the “buzz” word for the market, especially when it turns Red. Dr. Asness of AQR indicated in his recent post, the YTD annualized daily volatility of the S&P 500 Price Index as of December 17, 2018 was 16.5%, which placed the index at the 66th percentile over history dating back to 1928. In an earlier paper, Volatility Clustering, How to avoid the Tails?, we discussed the time varying and clustering nature of volatility, which means large positive changes in prices tend to be followed by large changes, and small changes tend to be followed by small changes, or volatility tends to persist in a cluster for some time. This is why clustering of best and worst days can be ingrained in declining markets. As markets trend upward, volatility declines.

At Convex, we estimate daily volatility across various markets using a statistical algorithm, including machine learning, and our volatility estimate as of December 19, 2018 stood at 19.52% in Cluster 4 within a band of of 1 through 5 based on both 252 days and 512 days estimate. In 2018, we already experienced a higher level of volatility, estimated at 29% on February 8th, which was in Cluster 5. This is not terrible as Dr. Asness puts it, “That just ain’t a very big number.” The real worry that an investor can have is that current volatility is a prelude to another 2000 or 2008. In fact, right now it looks much more like late 2015 and 2016.

As I mentioned in an earler post this week, the dramatic media headlines are roiling investor sentiment far and wide as the market declines. So, here is the real question : is the strong hue of Red in December, 2018 a hype, or does it indicate a trend?

The Efficient Market Hypothesis (EMH) asserts that if investors are rational, at any given time, security prices fully reflect all available information. Our hypothesis is that risk is time varying and investors require higher risk premiums during economic recessions and risk premiums should vary rationally and contemporaneously with economic and business cycles.

The relationship between economic and business cycles and risk premiums should be negative, i,e. when the economy is healthy, growing and consumption is high, investors are very willing to trade-off current for future consumption, leading to low expected rates of return on investments. Similarly, in a depressed economy, investors demand higher rates of return to switch current for future consumption. In other words, risk premiums should vary counter-cyclically with the economic and business cycle.

The Implied Market Risk Premium (IMRP) was calculated at 3.84 as of October 31, 2018 with an implied return of 6.99%, given a Risk-free rate of 3.15%. At its peak in October, 2008, the IMRP stood at 7.92, or more than 2 times higher than the current level. So far, the case for the Red(est) December in 2018 in 44 years to predict the comeback of 2008 (or worse) in 2019, could neither be supported by the level of volatility or by risk premium.

Now let’s turn briefly to the fundamental side. Total non-farm payroll employment in the U.S. increased by 155,000 in November, and the unemployment rate remained unchanged at 3.7 percent. Hiring and economic growth are strong, while business confidence in some measures stood at decade-plus highs. Companies continue to grow their earnings strongly, and that is expected to continue. From a fundamental perspective, although conditions are good, which should support stock prices and moderate any declines, businesses across the globe are anxious over the escalating trade war between the U.S. and China and the selloff in global stock markets. European companies are especially nervous, likely due to Brexit concerns and the social unrest in France. Global business sentiment is now as low as it has been since around the 2016 presidential election. President Trump told US lawmakers that he would reject a bill to fund the government into next February, staging a U.S. Government shutdown over his ambition of winning $5 bn to fund a wall at the US-Mexico border. The Fed on Wednesday also reduced its forecast for 2019 rate increases, from three quarter point rises to two, given rising risks across the global economy, from U.S. , Europe to Asia. In an earlier post, we have also discussed the evidence of Yield Curve inversion, which was a key indicator in each of the previous nine recessions. In short, there are definitely some concerns but the present situation does not portray the same macroeconomic picture with the elevated levels of risks as it did in December of 2007.

Related: Flight or Fight the Market by Sticking to Your Guns?


Now let’s look at the return and risk profile of the S&P 500 Index in a 10-year rolling period. As of November, 2018, the 10-year annualized return of S&P 500 Total Return Index stood at 14.32% with a standard deviation of 13.22% based on monthly returns. As a reference, the median return and standard deviation were 12.82% and 15.24%, respectively. This clearly shows that the current risk-adjusted return in US Domestic market, as measured by S&P 500 Index, ranks pretty impressive. In fact, the 10-year rolling return went below median in March of 2002, and only rose above median in October, 2018 despite the month’s return of -6.84%, because it replaced the return of -16.79% in October, 2008. Even if we include the blazing Red hue of December 2018 with YTD return of -9.07% as of the 19th, the rolling 10-year return of 13.11% still sits above the median of 12.82%. With all worries of rising volatility, the 10-year annualized standard deviation of S&P 500 Index at 13.61% (using monthly returns and MTD return as of 12.19.18) not only stood below the median, but it was also under the level at March 2002.

In short, if you bought an S&P 500 index fund a decade ago, you’re still sitting on a gain that’s uncommonly elevated since February of 2009 when it hit the trough at -3.43% and reached its peak at 14.32% in November, 2018. The level of elevation by the standards of rolling 10-year results i.e. the difference between the 10-year rolling return from its trough (February 2009) to peak (November 2018) was 17.75% that is spectacular, but which may also imply that something less impressive could be coming. As it appears from the chart, someone may interpret a technical analysis of 10-year rolling standard deviation rising above 10-year rolling return as an indication of a market regime shift, but the reliability of that signal is yet to be established.


The Red hue during the holidays is indeed fun, but market drawdowns are never fun. By understanding what drives them, however, you can rationalize the risk to anticipate whether the future could deliver more downside surprises, but also understand that the opposite is possible as well. Right now, the market is certainly in the “correction” or “alert” zone, but not necessarily in the “worry” zone. If you are worried, take this as a great opportunity to evaluate your investments with your advisor both to better understand the risks and adjust your asset allocation to account for your goals. By doing so, you would stand a greater chance of adhering to your specific goals and enjoy better long-term investment results. That is the most prudent way to deal with the markets during the holidays and enjoy the festive time with the hues of Red and Green.

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