from the brink
Another growth-stifling surge in global interest rates and new tension in the Middle East dragged stocks lower for a third consecutive month in October with the S&P 500 and Nasdaq 100 indexes both shedding 2.1% while foreign indexes MSCI EAFE (-4.0% Oct) and MSCI Emerging Markets (-4.0% Oct) indices fared no better, now negative on the year through October.
Total Return, Jul - Oct 2023. Source: TCM, Yahoo Finance. Click for larger image
Fulfilling its role as a low-correlation portfolio stabilizer that seeks to improve portfolio compounding, Alpha Seeker bucked the trend with its second consecutive monthly gain in October, lifting the strategy’s return since July to +1.8% versus a -5.3% decline for the S&P 500 and a -4.8% drop in the Bloomberg US Aggregate Bond Index (AGG: iShares US Aggregate Bond ETF).
Meanwhile, in another surge-and-retreat “pre-crisis” pattern (see chart below), VIX prices and TCM VIX exposure swelled during the most intense phase of the stock market decline, peaking just short of crisis levels on Friday 10/27 only to see the move reclaimed by a sharp equity bounce in the final two days of the month as a “tail” event failed to immediately materialize.
VIX crisis hedging concept. Source: TCM. For illustrative purposes only. Click for larger image.
With this pattern, producing a VIX profit requires treating VIX exposure as a “trade” and typically, selling protection just as a crisis appears to be emerging. While this may be appropriate for a purely tactical strategy like Alpha Seeker, the same approach effectively disables the crisis-hedging utility of VIX exposures in TCM’s Risk-Managed Indexing portfolios. For example, in October this would have meant selling hedges on Friday 10/27 at the brink of possible world war in order to preserve Tactical Beta’s modest +83bps advantage over the S&P 500 for the month at the time. Though it may have benefitted the strategy in the short term, this is the opposite of a crisis hedging approach.
With a lack of stock market “tails” and a series of moderate pre-crisis moves creating a cumulative hedge expense of roughly 12% for Tactical Beta even while stocks have struggled, the period since 2022 has been about as difficult as it gets for tail hedging strategies. If this period represented the full range of VIX outcomes, then these strategies would clearly make no sense. Of course, the full scope of market history strongly cautions against accepting this as the “new normal”.
For TCM’s approach, what is needed for a profitable VIX outcome is not a specific decline in the S&P 500 or the passage of some arbitrary amount of time, but an inverted VIX futures curve followed by crisis-level VIX prices (diagram below). Under these conditions last seen in March 2020, VIX exposure produced a 32% benefit in a single month for Tactical Beta and similar outcomes across all TCM strategies. Unless tail events have been permanently banished, we also expect substantial portfolio benefit at the conclusion of the current cycle.
barbarians at the gate
As we first discussed in “Divergence Emergence”, the relationship between short-term and long-term US Treasury rates is a closely watched metric with an unbroken track record of predicting recessions:
As a proxy for lending profitability, it is perhaps no coincidence that yield curve inversions have preceded 5 of the last 5 US recessions since an inverted yield curve creates a disincentive to lend that can lead to a contraction in credit that slams the brakes on a debt-based economy.
While the length and depth of a yield curve inversion determines the potential magnitude of a recession, the timing of one is more closely associated with a normalization or “de-inversion” of the curve that signals an imminent change to easier monetary policy. After the deepest inversion in 50 years, the 10 year - 2 year US Treasury yield curve is once again rapidly normalizing (top panel below).
Why is this relevant? While rate cuts eventually sow the seeds for recovery, they usually begin only after economic trouble is apparent and a recession is unavoidable. Especially in a highly leveraged economy, recessions substantially raise the risk of a financial crisis and the potential for crisis VIX levels (bottom panel above).
Judging by the length and depth of this cycle’s yield curve inversion, the coming recession threatens to be the deepest in 50 years and with total US debt about $25 trillion higher than the last time interest rates were this high, the risk of a financial crisis is extreme.
As we have repeatedly suggested, the best time to own a crisis-focused strategy is just ahead of the next crisis. History suggests that we may now be on the precipice of one.