Summary
Stocks lower in December, though mostly higher in Q4 and the last 6 months of the year
Q4 marks best quarter of 2022 for EAFE Smart Index, Emerging Markets Smart Index, Tactical Beta, Hedged Yield and Legacy Navigator strategies
Recent market stabilization and “event hedging” with short-term options has limited the VIX
VIX pricing remains cheap, increasing its potential in a future crisis
glass half full
Growth of $100, YTD 2022. Source: MSCI, Yahoo Finance. Click for larger image
US equity markets closed 2022 with a thud as the S&P 500 slid -5.8% in December and higher interest rates continued to weigh on the high-multiple tech and growth names of the Nasdaq 100 index (-9.1% Dec).
Outside of the US, a weaker US dollar and rebounding Chinese economy helped foreign stocks extend their recent outperformance relative to US markets (MSCI EAFE +0.8% Dec, MSCI Emg Mkts -1.6% Dec) while VIX futures capped an unusually tepid year by falling in tandem with the S&P 500 in December, dragging VIXY (ProShares VIX Futures ETF) to an unhelpful -25% on the year despite the decline in stocks.
This unusual combination is partially explained by the year’s sequence of returns that saw early weakness gradually give way to greater stability as the S&P 500 index saw a modest second half rebound and its first quarterly gain to close out the year. From a volatility perspective, stock market action after the June lows simply did not justify an aggressive bid for protection, at least in the options that move the VIX index (more on this below).
A rare but real phenomenon, positive VIX and equity correlation has been a challenge for TCM strategies in 2022, but was manageable enough for Q4 gains and the best quarter of the year for EAFE Smart Index, Emerging Markets Smart Index, Tactical Beta, Hedged Yield and Legacy Navigator strategies, while Alpha Seeker battled to a draw and Tactical Q and Hedged Disruptor continue to be dogged by the currently flagging growth factor.
Q4 2022 Net Return
Now & later
In the current rate hike cycle, equity markets have been bending but not breaking as the path of interest rates slowly evolves from one scheduled economic release to the next. Perfectly suited for this sign-post environment, CBOE’s listing of daily options expirations gave investors the ability to implement a precise “event hedging” strategy in 2022 using options contracts that expire in 24 hours or less, every day of the week.
Relative to monthly contracts, these daily options often make for a more efficient hedge around scheduled events such as the monthly CPI reports that moved markets in 2022. Following the money, investors dutifully piled in with daily contracts growing to represent nearly half of all SPX options volume by the end of the year (chart below).
Like any other asset, money flow changes the prospects for this and related areas of the market. Most relevant for TCM strategies, demand for limited-scope “event hedges” can compete with longer-term (23 to 37 day) contracts tracked by the VIX index, potentially impacting VIX behavior during headline-based environments like 2022.
However, this process also works in reverse. During a crisis environment with few sign-posts, the focus on short-term efficiency can give way to a scramble for longer-term protection and a sudden rush back into the options that create VIX spikes. Having identified a new winner, human nature is left take its course in a virtuous cycle of rising prices, new narratives and surging inflows into VIX and related exposures until conditions change once again.
Rather than restraining like a seatbelt, the VIX tends to deploy on contact like an airbag and a lack of deployment under present conditions says nothing about its future potential. In fact, from today’s bargain levels and with the unknown impact of Fed rate hikes lurking, we believe VIX exposures have rarely been more attractive.