Trades for a Low-Volatility Market

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Editor's Note: This column by Scott Rothbort is a special bonus for RealMoney readers. It appeared on Street Insight on Jan. 26. To sign up for Street Insight, please click here.

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Having a large database of information, I like to look for historical parallels to current market conditions. An interesting analogous situation exists between the S&P 500 for the period of October 1952 to January 1953 and October 2004 to Jan. 19, 2005.

To view a larger version of these charts (in some browsers), after clicking on the "larger image" link below the chart, mouse over the lower-right area of the chart until the icon with four arrows appears. Then click on that icon.

S&P 500 Oct. 1952 - Jan. 1953 vs. Oct. 2004 - Jan. 2005

Click here for larger image.

Source: Bloomberg and LakeView Asset Management

There are a few points of similarity worth noting about these periods:

1952 was a presidential election year, as was 2004.

The chart of the unitized returns for both years (below) is remarkably similar.

While the data are sketchy for the 1950s, it appears the federal funds discount rate was at or near a low in the early part of that decade. At that time, the rate was around 1.50% to 1.57%, and it began to increase through October 1957 to a peak of 3.50%. In the current fed cycle, the discount rate bottomed at 0.75% in 2002 and now is up to 2%.

From the point in time of January 1953 that coincides with the close on Jan. 19, 2005, the SPX price return through Dec. 31, 1953, was -5.02%. This certainly makes a bearish case for the balance of 2005.

The first three quarters of 1953 registered a 12.12% decline in the index. So far this year, through Jan. 19, the SPX was off 2.25%. This adds to the bearish case for the next few months.

After the third quarter of 1953, the S&P went on to 10 straight quarterly increases for an aggregate advance of 106.03% through the end of March 1956. This is the bullish silver lining in the clouds noted in the two points above.

Approximately 18 months prior to the beginning of each year, hostilities broke out, resulting in the U.S. entering a war. For the periods we're discussing, it's the Korean War and the Iraq War.

Interpreting Without Bias

When trying to understand the markets in a historical context, I try to use an unbiased measure as my benchmark. I have developed a proprietary measure of volatility, the VDEV, a measure of the standard deviation of the day-to-day percentage changes in the S&P 500. Using this, I compared the standard deviation for the periods of time in question. Please note that since 1950, the average for the VDEV is 0.805%. (The VDEV is predictive of the VXO implied volatility index.) Below are the graphical results for the same period of time as the S&P 500 results I posted above:

VDEVs Oct. 1952 - Jan. 1953 vs. Oct. 2004 - Jan. 2005

Click here for larger image.

Source: Bloomberg and LakeView Asset Management, LLC

Again, I have some observations:

Both periods were highlighted by below-average periods of volatility.

The 1952-53 period was less volatile than the 2004-05 period. Hence, the bears' argument that we currently are at historically low levels of volatility is not the case.

What is in my data but not represented in the chart is how volatility looked from February to December of 1952. Basically, the VDEV rose to just under 0.76% by mid-April 1953 and ended the year at 0.45%.

Because there were no volatility spikes in the 1952-1953 period -- and I do not foresee one this year, without some unexpected event -- I believe the SPX will not move dramatically in any single direction. However, we could close lower, as in the 1953 period. But I also expect that an actively managed portfolio probably will outperform the major indices.

Let's ask another question: Do years subsequent to election years matter? Below is the SPX price return for the year following an election since 1950.

There seems to be one discernable trend. It appears the first year after a Republican is elected to the top job in Washington, D.C., is not a very good one for the market. The above data show two up years and six down years with the net of all occurrences being down, though for Republican incumbents, it was one up and two down. The average return for all occurrences of an incumbent being elected is 6.94%, regardless of party affiliation.

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At the time of original publication, Rothbort was long Novell, McDonald's, PalmOne amd Research In Motion, long calls on McDonald's and short Red Hat, although positions can change at any time.

Scott Rothbort has 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers both individually managed accounts and a hedge fund to its clientele. Prior to that, Rothbort worked at Merrill Lynch for 10 years. Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is an adjunct professor for the Stillman School of Business at Seton Hall University.