Monday, October 01, 2012

Bank Stock Timing Strategy

My bank vega theory I alluded to yesterday argued that when banks are weak, they are in a negative vega zone: the potential for getting stopped out makes them want to avoid risks, not take them. For fun, I looked at a trading implication, based on the idea that I alone, via my theory, know when banks will be timid or growing.  A timid bank doesn't make money, so it's best to avoid it then. It's not short term enough for it to be really useful, so I'm sharing, and I think all investors thinking about their bank index allocation should find this interesting.

A calculated a backward-looking correlation of the past 252 days of daily bank returns with the changes in the VIX index, because Ken French's website has daily returns for a bank index going back to 1986, I have VIX data from 1986, and I can update this with the KBX bank index for more recent daily data.

I then take this correlation, and find its median. I then say, invest in the SP500 when this correlation is high in absolute terms (very negative, all correlations with the changes in the VIX are negative), I don't want to invest, because the banks won't be investing and making money. In the 50% of the time that correlation is low (again, in absolute value), I'm in the banks. Here's a comparison of that strategy, and clearly timing based on the bank-VIX change correlation outperforms simply being always long banks.

Here's what it looks like in Scatter-Plot, comparing the future 3-month return in the two regimes.  The black vertical line in the center is my best stab at putting a median in there.

We are currently at -70% for a correlation, still bad for banks (median around -62%). This is all out of sample, and a pretty simple rule. I did try this with Ken French's other industries, and found no similar pattern.  


Unanimous said...

You compared your bank timing method with always being in banks, but how does it compare with always being in the SP500?

Eric Falkenstein said...

Banks we up about 6.5 times over that period, vs. 5.0 times for the SPX, so, going to that index should bring it down if random.

Anonymous said...

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Eric Falkenstein said...

hmm. Sorry about that...those free sites that offer file storage have lots of strings attached.