phase ONE
YTD Returns as of 11/10/2022. Source: Yahoo Finance. Click for larger image
The sharpest interest rate increase since the 1970s brought QE-fueled multiple expansion to a screeching halt in 2022, crushing valuations in nearly every asset class with particular focus on high-multiple tech and growth stocks.
With the rate hike band-aid mostly ripped off, by summer stocks began to find some footing as signs of slowing inflation stirred hope for a Fed “pivot” just in time to avoid a recession. Bidding most stock indexes higher since June 15, investors appear willing to give the benefit of the doubt to this scenario with dismal historical odds.
Despite a -15.9% loss for the S&P 500 on the year through Nov 10, VIX futures (VIXY: Proshares VIX Futures ETF) have posted performance more typical of an equity bull market, declining -8.3% over the same period and creating a drag rather than a cushion for TCM’s Risk-Managed Indexing strategies that use similar exposures to hedge equities.
YTD Return as of 11/10/22. Source: Yahoo Finance, TCM. Click for larger image
Like any VIX outcome, this is ultimately a result of demand in the S&P 500 options market. Often trading with high implied volatility, S&P 500 “crash” or “tail” puts have an outsized effect on the VIX index, creating its characteristic spikes as their demand jumps in fast-moving markets or limiting VIX levels as demand falls when smaller moves are expected. During a measured decline triggered by well-telegraphed Fed action, lack of demand sent the price of tail options (Nations TailDex Index) to a 10-year low in 2022, limiting VIX in this phase of the decline while simultaneously increasing its spike potential when demand returns in a future panic.
Nations TailDex Index (TDEX), 01/31/2005-10/31/2022. Source: Nations.com. Click for larger image
In cycles that often take years to play out, the ebbs and flows of monetary policy give rise to business cycles that create the large VIX “loops” observed throughout its history. Were it to hold, the year’s closing high of 36.45 would represent one of the lowest bear market peaks in VIX history, suggesting that the current loop is not yet complete.
VIX Index Long Term “Loops”, 01/01/90 - 11/10/22. Source: Yahoo Finance, TCM. Click for larger image
As the basis for asset valuations and funding markets around the world, the importance of US interest rates can hardly be understated and shocks like last year’s are likely to reverberate for years. After weathering the sharp policy adjustment phase, investors must now contend with its consequences that are much harder to anticipate and are likely to surface with variable lags and in unexpected forms. This new phase is fertile ground for the panics and scrambles for “tail” exposures that create significant VIX spikes.
“No amount of sophistication is going to allay the fact that all of your knowledge is about the past and all of your decisions are about the future.”
Who’s on First
An exceptionally difficult year, 2022 was a hard lesson on the risks of “first order” analysis that assumes an investment’s prospects to be determined by past outcomes rather than present factors.
In 2022, first order portfolios struggled as new conditions favored previously-neglected approaches over last year’s winners, including a stunning -42% YTD loss for Amazon (AMZN: Amazon.com Inc) through Nov 10th, a pace which puts the stock near $0 by 2024 and by first order reasoning, turns last year’s “buy” into a “sell”.
To avoid this familiar (and unprofitable) first order cycle requires judging an investment’s prospects by its driving factors in light of present circumstances. Considering Amazon, this “higher order” framework might ask questions like: What are the most significant factors for the company today? How are they likely to change in the months ahead? Does the current stock price fairly reflect these probabilities? The ultimate conclusion may still be a “sell”, but it will have come as a result of more thoughtful analysis that raises the odds of long-term investment success.
It is a first-order statement of historical fact that VIX exposures did not hedge equities well in 2022. To assess future prospects for the VIX, higher order reasoning might consider current factors like the implications of historically cheap “crash” put exposures in the context of the often destabilizing and lagged effect of rate hikes (see chart below). Put another way, the same factors that have weighed on the VIX this year have also changed its future potential. Like the proverbial “glass half full”, the judgement that follows is only a matter of perspective.
Fed Funds Effective Rate and VIX Index, 1955-2022. Source: St Louis FRED. Click for larger image
In any endeavor, a series of first order decisions is rarely the recipe for success; it is telling that both Steve Jobs and Warren Buffet have used Wayne Gretzky’s famous “skate to where the puck is going” line to describe their approach. With the market “puck” picking up speed, an investor’s choice of focus today is increasingly important for ending up in the right place tomorrow.