In our Schaeffer's Media Outtakes series, Bernie Schaeffer dissects the news, using contrarian analysis to provide a unique take on the market.

"Johnny Hedge Fund: You'll go nuts fighting the Fed. The Bernanke put is bigger than Greenspan's.
Real Money Portfolio Manager: Another rate cut just means we're in even bigger trouble. That's why I'm using the VIX at 17 to re-hedge. Only a fool shorts October volatility."
----(Barron's "The Striking Price" 10/1/07)

Schaeffer's addendum: Steven Sears of Barron's provides us this week with some lively dialogue between a fictional hedge fund manager (whose long/short portfolio is down for the year) and a more traditional portfolio manager who is in the plus column.

I was particularly struck by the contention by the portfolio manager that "only a fool shorts October volatility." Table 1 below shows the average returns for each calendar month from January 1987 to date, along with the standard deviation of these monthly returns plus the percentage of monthly returns that were positive. Table 2 is identical in format and calculation, except it begins with 1988, thus excluding the impact of the October 1987 market crash.

What is clear from Table 2 is that since January 1988, October has produced the third-best monthly return (1.89%, lagging only November and December) along with the third-lowest volatility. Of course, if you add 1987 into the mix as Table 1 does, October becomes a mediocre month in terms of returns and sports the highest volatility.

So is October a great month in which to load up on stocks (high return with low volatility) as Table 2 tells us, or a month to fear (low returns with high volatility and a crash 20 years ago) as Table 1 implies?

It appears that the portfolio manager concocted by Mr. Sears is afraid of the so-called "black swan" event in the form of a market blow up in October 2007 analogous to that which occurred in the same month in 1987. But I feel this is a misapplication of the black swan concept as developed by Nassim Taleb.

I quote here from Taleb's latest work ("The Black Swan"):

"What we will call here a Black Swan (and capitalize it) is an event with the following three attributes.

First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predicable."

I would argue that the fear of a market crash in October 2007 because there was such an event in October 1987 is precisely not a black swan issue, because one is implicitly looking for history to repeat itself. But according to Taleb, nothing in the past can convincingly point to the possibility of a black swan.

In other words, we should all fear black-swan events, but specifically because we recognize that "we don't know what we don't know." The fear of an October 1987 market crash re-occurring in the corresponding month in 2007 can be restated as "I know what I know - there was an October crash twenty years ago so I fear its recurrence this October." And I submit this has nothing to do with Taleb's black-swan concept.

My take is that Table 2 much better describes the October situation in modern history than does Table 1. This does not mean that a black-swan event cannot occur this month (or occur in any month for that matter) - but if it does occur it will be entirely unrelated to the fact that there was a crash in October 1987. So if you like months with seasonally strong returns and low volatility, you just might want to hike your long exposure as we move into October. The smart money could well be represented by those who are "long October volatility," with a marked bullish bias.

Copyright Schaeffer's Investment Research http://www.schaeffersresearch.com

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