a tale of two markets

VIX futures (VIXY: ProShares VIX Futures ETF) fell nearly straight through the S&P’s 8% range in May, bucking the usual relationship and amplifying rather than offsetting equity declines in 2 of 4 weeks during the month. While episodes of positive correlation with the S&P are frequent throughout the history of the VIX, this one compounds an already challenging year in which a very weak VIX / S&P relationship has kept hedging profits elusive for TCM portfolios (more on this below).

*MTD Return, May 2022. Source: Yahoo Finance*

In a notable change of character, Treasury yields also fell throughout the equity turbulence in a sign that the bond market may be growing concerned about a recession stemming from the Fed’s efforts to stamp out inflation. This highlights the delicate balance needed to engineer the vaunted “soft landing” where growth is slowed just enough to contain inflation while still avoiding recession. As the main issue facing equity markets today, the future path of interest rates bears watching and keenly aware of the Fed’s track record of failure in this regard, bond markets tend to be wary of any potential overshoots in either direction.

Where’s The VIX?

TCM’s risk management process is simple: buy VIX futures when they begin to show signs of stress, aiming to offset equity declines as their value further increases in a subsequent crisis. Over the past six years, this method for balancing hedging cost and effectiveness has produced results that have attracted significant assets, not through a string of continuous victories but from a handful of critical moments when the explosive “skew” of VIX exposure protects portfolios more like an airbag than a seatbelt. Though the process is consistently applied, its results vary with the VIX / S&P relationship that is unique to each period.

The most constructive VIX / S&P combination was seen during the Q1 2020 “Corona Crisis” when strong stress signals and exponential returns from VIX futures produced a powerful offset to a dramatic and broad-based waterfall in stocks (see chart below). Again, this hedging impact was not evenly distributed throughout the quarter, but came during a handful of critical moments as stocks crashed and the VIX “airbag” deployed in early March that year.

*YTD Performance, Q1 2020. Click for larger image*

Despite a significant decline in stocks, hedging markets in 2022 are complacent by comparison. With no VIX index closes over 40 on the year (vs 33 such closes through May of 2020), a 2-year low in the “VIX of VIX” (VVIX index) and anemic returns from VIX futures (VIXY: ProShares VIX Futures ETF), investors appear to be reducing rather than increasing hedges during this year’s declines to date, perhaps taking comfort in the wide S&P sector dispersion thus far (see chart below).

*YTD Performance, May 2022. Click for larger image*

While it lasts, dispersion can keep a lid on S&P 500 index volatility (the VIX index), but ultimately a sustained drop in asset values risks triggering the type of indiscriminate selling last seen in 2020, either directly through margin calls or indirectly as retail investors (typically holding index funds) eventually leave the market en masse. These waterfall markets are where VIX often becomes unhinged and acts as a powerful equity hedge, as demonstrated in March 2020 by Tactical Beta’s 32% outperformance of the S&P 500 in a single month.

when the dealing’s done

Perhaps recalling its last hasty retreat in 2019, hedging markets seem to be calling the Fed’s bluff in 2022 by refusing to panic despite the decline in equities. This has weakened the VIX / S&P relationship and blunted the effectiveness of VIX-based hedges to this point, but the game is not over. Eventually one side must fold, either the Fed by appeasing stocks and calling off its tightening program, or with another VIX “geyser” as investors reassess the odds of another Fed-induced market crisis.

Either scenario is likely to restore the VIX / S&P relationship to the benefit of TCM strategies. With continuous index exposure, TCM Risk-Managed Indexing strategies stand to benefit most from a recovery in stocks in the case of a 2019-style Fed capitulation. If instead, the Fed sticks with its rate-hike plans and markets capitulate, a 2020-like cascade could provide another VIX “airbag” moment that has helped to produce the results that attracted so many to TCM strategies in the first place.

To believe that the current VIX complacency and equity declines will persist is to believe that the Fed manages to normalize rates without sparking a crisis, something that they have never been able to do. There is a first time for everything, but we will continue to prioritize a proven process over speculative bets.