In psychology, "recency bias” is the term that describes our tendency to use the recent past as the baseline for what will happen in the future. While recent action in markets might suggest that 20 is a ceiling for the VIX Index, that idea is absolutely not supported by the full VIX data set. Far from a cap, the “bear market” zone above 20 is actually the second most common level for the VIX, comprising 36% of all closes since 1990.

Recency bias has the ability to turn what were extremely impactful, emotional periods into an historical relic. With many painful events this is more a blessing than a curse, but for historically common investment “traumas”, it can lead to an overly-lax attitude about risk, especially at the end of bull markets when it is needed most. On the 11th anniversary of one of the worst-ever periods in modern markets, it’s eye-opening to re-live the emotion of these experiences as they happened:

It has become popular to dismiss the events of 2008 as a freak occurrence that were completely unpredictable and never to be repeated. In reality, there were many warning signs that provided those who were paying attention ample time to prepare. In particular interest for our process was the change in character in the VIX complex starting more than a year prior, in February 2007.

*S&P 500 Volatility Risk Premium, 2004-2007*

After spending months near the lowest readings in history, on Feb 27, 2007 the VIX index spiked +64% on news of a dramatic decline in Chinese stocks, its largest one-day move in history to that point. It was not known at the time, but this event set in motion a steady climb for volatility that would eventually culminate 20 months later in the panic of 2008. In the early stages of this period, disruption of the typical “looping” process in the VIX meant that rather than the usual over-estimation, expectations for volatility were often met or exceeded. Like recent experience, this narrowing of the so-called “Volatility Risk Premium” (VRP) impacted strategies designed to profit from it, with Alpha Seeker notching the only down year in its backtest period while the S&P 500 posted a gain in 2007.

This environment stretched into the first half of 2008 as economic data continued to deteriorate and other warning signs mounted, most notably the failure of Bear Stearns which caused the VIX to briefly break 30 in March. Even still, markets remained resilient as the Fed aggressively cut interest rates while assuring investors that it was not forecasting a recession. After the rescue of Bear Stearns, the S&P 500 regained its footing as the VIX fell sharply and VRP briefly reappeared for a few weeks through mid-May. Then the real trouble started.

With the housing market continuing to crumble and as banks began to fail throughout the summer, it became increasingly clear that lending giants Fannie Mae and Freddie Mac would need assistance if they were to survive. With rumors now swirling about the viability of investment firms with sub-prime mortgage exposure, the VIX resumed its climb, surpassing 30 for the third time on the year on news of the failure of Indy Mac bank in July. In a final “warning shot”, a burst of hope around the rescue of Fannie Mae and Freddie Mac was not enough to push the VIX sustainably out of the “bear market zone” above 20. By the end of August, with Alpha Seeker flat on the year after struggling through 18 months of dwindling VRP amid a faltering stock market, the fireworks were ready to begin.

Contrary to popular belief, very high VIX values do not come from a rogue event- they are typically the result of financial contagion in which a single shock propagates out in multiple directions at once, exponentially increasing uncertainty. Beginning with the nationalization of Fannie Mae and Freddie Mac, the timeline of events in the fall of 2008 is a classic example and importantly, one that would have been possible to avoid or even profit from in real-time using the right indicators.

*VIX Index and Futures, Sep-Oct 2008. Source: CBOE, TCM*

The chart above shows the VIX Index (grey line and black dots), VIX futures (red dots, inset chart) and just a portion of some of the major headlines during the September - October 2008 period. Aside from the sheer drama of that time, what is most striking to us is the fact that the VIX futures curve first inverted (1st VIX future price closed higher than 2nd VIX future price) only after the Lehman Brothers bankruptcy on Sep 15th, with the futures at roughly 25. In other words, at the gateway to one the most devastating periods for markets in this century, there was a warning sign.

An inversion of the VIX futures curve is one of the primary signals in our system and those who heeded it on Sep 15, 2008 could have benefited as volatility exploded in the ensuing chaos, despite the coordinated efforts of world central banks to control it. Although the product hadn’t yet listed, the index tracked by the iPath Short Term VIX Futures ETN (VXX) jumped as much as 273% from Sep 15th through year end. With a move of this magnitude, it doesn’t take much exposure to make a meaningful difference for a portfolio, whether from a discreet allocation to Alpha Seeker as part of a diversified portfolio or with an integrated risk-managed exposure like Smart Index.

For passive index exposures, the damage from these few months erased 11 years of gains and took another 6 years to recover- assuming an investor had the luxury of that much time to spare. Unfortunately for many others, 2008 permanently impaired their retirement plans and was never fully recovered. Even a partial offset of the bear market losses could have bought those investors valuable time as their portfolios would have resumed compounding much sooner during the post-2008 recovery. Rather than a once-in-a-lifetime event, the same can be said of any of the bear markets that have occurred in every decade of the last 70 years.

At TCM, we believe better portfolios come from a focus on compounding- the “eighth wonder of the world” and the key to maximizing a portfolio’s long-term value. This is a task that requires as much attention to risk management as it does to maximizing upside, and is why we designed risk-responsive investments that can be incorporated into most any portfolio.