Summary
Stocks higher in January as “soft landing” odds increased
Notable strength in foreign equities
Volatility continues to decline along with inflation
The soft parade
Growth of $100, Oct 2022 - Jan 2023. Source: MSCI, Yahoo Finance. Click for larger image
After reports of moderating inflation and a solid job market supported the “soft landing” scenario that sees inflation subdued without a recession, equity markets started 2023 on an upbeat note with the S&P 500 (+6.3% Jan) and Nasdaq (+10.6% Jan) erasing nearly a quarter of last year’s loss in January while MSCI EAFE (+8.1% Jan) and Emerging Markets (+7.9% Jan) indices added to their already impressive rallies from Q4 lows (chart above).
A major advantage of tactical risk management is its cost efficiency while not deployed, and in January this produced significant outperformance for Tactical Beta (+4.8% Jan) and other TCM Risk Managed Indexing portfolios relative to traditional “always on” hedged strategies. As demonstrated over the past 6 years, this advantage compounds as markets rise over time and if the soft landing scenario actually comes to pass, “fear of missing out” could once again replace “fear of losing money” as the chief source of investment concern.
From the stabilization in equities to corporate credit spreads and the VIX both stopping short of crisis levels (chart below), markets have been pointing to this benign outcome since last summer’s inflation peak strengthened the case for less aggressive monetary policy. This optimism so far appears justified, but with the market now expecting rate cuts in 2023 in defiance of Fed assurances to the contrary, the stage could be set for future volatility.
VIX Index vs HY Corp Credit Spread. Source: St. Louis Federal Reserve. Click for larger image
so last year
Rather than a crisis tidal wave, 2022’s volatility “loop” resembled the slow swell of inflation as it rose and fell almost symmetrically around its mid-year peak, producing polar opposite market outcomes that highlighted once again the limitations of managing investments using first-order analysis that prioritizes past over present conditions. (See “Who’s On First”, TCM 2022 Year In Review)
CPI y/y change vs VIX index, Jan 2021 - Dec 2022. Source: St Louis Federal Reserve. Click for larger image
After the uncomfortable adjustment as inflation rose in first half of 2022, a first-order investor who then sold stocks assuming more of the same has now compounded the issue by missing an +8.7% gain for the S&P 500 and nearly 15% for the MSCI EAFE index as inflation has subsided since July 2022. The path was not an easy one, but it appears the VIX has so far been proven correct in not pricing much beyond the unremarkable realized volatility of this episode (chart below).
VIX Index vs S&P 500 realized volatility, Jan 2020 - Dec 2022. Source: Yahoo Finance, TCM. Click for larger image
Of course, last year’s outcomes were the result of last year’s conditions and they say little about the likely response to different circumstances in the future. If the soft landing camp is right, then VIX should track realized volatility lower as equities rise, turning hedges back into a burden for “always on” hedged portfolios like they’ve been over the past few months. In a more negative scenario, the market could see a sharp repricing that causes crisis-level volatility and the kind of VIX spike that has driven TCM’s outperformance over the past decade.
Especially when market conditions are changing rapidly, steering portfolios from the rear view mirror is a recipe for failure. It’s not always easy, but we’ve found that staying aligned with present conditions is usually the best way forward. Feel free to schedule a webinar at any time to discuss in more detail.