“If it keeps on raining
The levee’s going to break”

— Led Zeppelin

pouring rain

*S&P 500 First Half History, 1928-2022. Source: Compound Advisors. Click for larger image*

Skidding to its worst opening half since 1940 (see table), the S&P 500 shed 8.3% in June as consumer sentiment hit an all-time low amid a 40-year high for inflation and aggressive tightening by the Fed that threatens to slam the brakes on an already fragile economy.

Yet despite the torrent of bad news, hedging markets remained curiously aloof with VIX futures (VIXY: ProShares VIX Futures ETF) rising just 4% on the month, compared to over 100% during the crisis in March 2020.

Not confined solely to the VIX, complacency was evident in both the St. Louis Fed Financial Stress Index which dropped to a record low dating back to 1993, and in the options market where the demand for downside protection via S&P 500 put options as measured by the Nations SkewDex Index sits at levels more typical of a raging bull market than a catastrophe. Misguided or not, investors are confident that equity declines will continue to be measured and will avoid the dramatic moves typical of past crisis periods.

*St. Louis Fed Financial Stress Index, 2008-2022. Source: St. Louis Fed FRED Database. Click for larger image*

As the Pendulum Swings

Hedging equity risk with VIX exposures requires a sufficiently negative VIX / S&P 500 relationship. Like the VIX itself, this relationship is variable but highly mean-reverting, displaying a strong tendency to move away from extremes toward its long-term average. In 2022, the VIX is showing underreaction to an S&P 500 decline witnessed only twice in the VIX futures era since 2004.

As marked by the orange dots in the chart below, simultaneous declines of this year’s magnitude in both VIX futures and the S&P 500 were last recorded in August 2011 and September 2008, on the eve of two market crisis periods that caused the VIX / S&P “pendulum” to swing firmly in the opposite direction, from negative to strongly positive VIX hedging potential in a short period of time.

*VIX complacency extremes, 2004-2022. Source: CBOE, TCM. Click for larger image*

VIX complacency is a challenge for equity hedging strategies, and particularly for those that hedge with VIX exposures directly. However, variations of the VIX / S&P relationship are to be expected and with VIX complacency now at another historical extreme, it’s likely just a matter of time before the pendulum swings back. A beneficial “swing” could come in the form of a market crisis and a large VIX spike, but it can also occur with a strong S&P 500 rally. For a strategy that holds 90%+ equity exposure and hedges only tactically with VIX exposures, either scenario would be a welcome one.