PIVOT DIVOT
A much-anticipated speech by Fed Chair Powell threw cold water on “pivot” hopes in August, capping the summer’s rally right at the widely watched 200-day moving average and dragging equity indexes about 4% lower on the month. In a welcome sign of normalization, the VIX index mirrored the action in stocks with a sharp bounce during the stock pullback producing modest hedging gains for TCM strategies after defensive positions were initiated late in the month.
S&P 500 and VIX Index, 2008 vs 2022. Source: Yahoo Finance. Click for larger image
With the VIX index at pre-crisis levels and stocks still holding a pattern of higher lows since the “pivot” rally started in June, the jury is still out on whether this is simply a correction in a new uptrend for stocks or the start of the next wave lower. Ominously, the rejection of the mid-year rally at the 200-day moving average bears a striking resemblance to the 2008 crisis which turned violent after months of VIX complacency in the face of building pressure that year (see chart above).
Then as now, central banks continued to fight inflation with rate hikes as late as July 2008 even as a sharp reversal in commodities was signaling an imminent recession. Indeed, as estimates for interest rates continue to rise in 2022, significant ongoing reversals in oil, copper and lumber (chart below) have gone largely unnoticed. No two markets are identical, but the parallels with the last financial crisis are undeniable.
Lumber price, YTD 2022. Source: Macrotrends.net
where the wild things are
TCM portfolios apply a consistent process to capture an inconsistent benefit- the VIX “skew”, or its historical tendency to produce positive outlier events. Like so many times this year, TCM portfolios have begun the first stage of this process, deploying an initial tranche of protection as a turn in markets begins to invert VIX futures pricing. Should the inversion deepen, hedges are increased until the VIX enters crisis territory where its positive outlier events live. With VIX exposure at maximum 30%, these events can then produce a massive hedging benefit.
Just like the process of building hedging exposures, outlier moves in VIX usually come from a series of moves higher rather than a singular event. Stuck in a YTD range between 20 and 35, there has so far been a lack of follow-through as the VIX reflects generally elevated risk that has not yet crescendoed into an acute crisis. Heading into winter with an energy crisis crippling Europe while inflation rages and US housing implodes, risks remain high with no easy solutions apparent.
With powerful economic incentives to keep VIX and S&P markets aligned, the tension from this year’s VIX complacency now resembles a beach ball being held under water, presenting significant potential when one side or the other finally bursts to the surface. As previewed by this summer’s 18-20% “hope” rally in stocks, a market-positive scenario could see a powerful equity rally as inflation begins to decline and allows the Fed to return to more accommodative policy before earnings or employment suffer major damage. In a less optimistic scenario, a new issue could ignite a panic over financial contagion that inverts the VIX curve and finally sends VIX into crisis territory where an outlier event enables another dramatic hedging benefit.
We have a plan for both scenarios, but the market will only move in its own time. In the meantime, we will remain consistent while we let the inconsistent come and go.