Please enjoy this piece from our partner Little Harbor Advisors offering perspective on the current VIX landscape in comparison to past crisis periods.
VIX Dynamics in Crises
As practical observers of equity market volatility, Little Harbor Advisors would suggest that the time is now for a systematic market-hedge. The dynamics between the VIX and the S&P 500 last year may mark a gateway to an impending crisis.[1] Declining markets with nervous range-bound VIX between 20 and 35, as we have experienced in 2022 and into this year, have occurred repeatedly in the past and in each case preceded second-leg crises with VIX spiking to well above 35 – when most of the value destruction generally occurred. A range-bound VIX between 20-35 reveals common markers and dynamics which distinguish them as potential “crisis gateways” that deserve a defensive posture.
2022 was a challenging period for passive allocations to US equities generally and to the S&P 500, in particular, which ground down 24.5% through October 12th from the market peak on January 3rd before regaining its tenuous footing into the first quarter of 2023. As of March 31, 2023, the S&P 500 was down 12.5% from its prior peak, having retraced about 50% of its losses. The VIX during this period remained range-bound between 20-35, which indicated a transitioning VIX market. Not all transition VIX markets are followed by crises, but we believe there is a high probability that the current declining transition market off its high has the potential to become a crisis.
S&P 500 and VIX in Perspective
To place 2022/3 in perspective, the chart below illustrates the S&P 500 and the VIX indices going back to December of 1990. The S&P 500 index is presented in logarithmic scale to visually compare the 2022 decline in the context of the other secular crises and episodic shocks affecting the equity markets since 1990. For ease of reference, the corresponding VIX index chart is divided into three color levels – green, yellow, and red which are typically associated, respectively, with “Calm VIX,” “Transition VIX,” and “Crisis VIX:”
S&P 500 and VIX index, 1990-2023. Source: Little Harbor Advisors. Click for larger image
Despite the 2022 losses in the S&P 500, the absolute level of the VIX in 2022 remained squarely in the yellow Transition VIX zone, which has been most observably similar to the run-ups to the last two secular crises of the Global Financial Crisis (GFC) in 2008 and the Tech Bubble in 2001. The COVID crisis, by contrast, experienced a very a sharp increase in the VIX as a result of an episodic shock similar to the Russian Financial Crisis of 1998, Flash Crash of 2009, the European Debt Crisis of 2012, and the China Crisis of 2015.
The primary difference between “Secular Crises” and “Episodic Shocks” is the length of the Transitional VIX period. When the S&P 500 is declining in a Transition VIX period, it is generally a “gateway” to a Crisis VIX period.
Dynamics of Episodic Shocks
Episodic Shocks typically proceed from Calm Market VIX to Crisis VIX in relatively short periods of time. As the name suggests, an Episodic Shock occurs when a perceived threat to the US stock market has the potential to create a crisis. In our experience, VIX levels above 35 corresponds to a meaningful two standard deviation divergence from the VIX mean of 20 – which typically occurs when there is consensus in the market that a systemic risk exists which needs to be broadly hedged with S&P puts.[2] Episodic Shocks are generally not tied to the fundamental secular dynamics of the US economy and tend to account for smaller market drawdowns.
The Dynamics of Secular Crises
One of the key characteristics of rarer Secular Crises is that they coincide with cycles of economic recessions. One of the major reasons that the S&P 500 declines in extended Transition VIX periods is that investors are not using puts on the S&P 500 as a systemic hedge but are rather rotating leadership in their stock allocations and contributing to the controlled decline in what they view as a correction opportunity. Investors use periods of lower cross-correlations to pick leadership diversification within equity indices like the S&P 500 and, generally, continue to do so as long as stock fundamentals exist and there is little perceived systemic risk in the market.
However, picking leadership diversification begins to deteriorate in the late-cycle lead-up to Secular Crises. This has typically been associated with large increases in stock price cross-correlations in the equity markets due primarily to the deterioration and collapse of market breadth – strong indications of breadth deterioration occur when the majority of stocks in the S&P 500 have negative forward earnings, the majority of stocks are trading below their 200-day moving average, or the percentage of stocks outperforming the index fall to new lows.
In the Tech Bubble and GFC Secular Crises, the observed “gateway” between Transitional and Crisis VIX levels was when the systemic risk of a US recessions was fully priced into the market and there was little benefit from sector or stock selection as correlations converged. In this environment, the lack of diversification leaves no option but to hedge the S&P 500 index. In those instances, the VIX above 35 signaled the capitulation of the S&P 500 and the final stages of value destruction in the market.
Crisis Gateways Generally Occur Halfway
The following table illustrates the disaggregation of drawdowns since 1990 into their Transition VIX and subsequent Crisis VIX components:
Source: Little Harbor Advisors. Click for larger image
As one would expect, Secular Crises have larger total drawdowns and demonstrate long periods of Transition VIX before capitulating to Crisis VIX levels when recessions get priced into the market. Episodic Shocks have lower total drawdowns and shorter Transition and Crisis VIX periods. In both cases, however, the Transition VIX and Crisis VIX have each contributed roughly equally to the total crisis drawdowns (with the notable exceptions of the GFC and the COVID Crisis when 60% and 70%, respectively, of the value destruction occurred during Crisis VIX periods). In both cases, the crossover from Transition VIX to a Crisis VIX is almost always accompanied by a pronounced inversion of the term-structure of the VIX into backwardation (an indication that there is more near-term fear than long-term fear).
COVID Crisis – Perfect Storm
The exception to an easier categorization into Episodic Shock or Secular Crisis was the market reaction to COVID, which was a simultaneous consensus response to the shock of a fearsome pandemic and to its recessionary fallout – which both warranted massive participant hedging of the S&P 500 index to offset quickly evident systemic risk in the market. The structure of the COVID crisis was unique in its speed and scale. The Transition VIX period was very brief with an -8% S&P 500 decline, followed by a large -26% decline associated with Crisis VIX levels. Further declines were likely stemmed by the reassertion of massive monetary intervention, zero interest rate policy, and extraordinary fiscal stimulus programs.
2022/2023 – Gateway to Crisis VIX?
Hedged equity strategies which use the VIX as a hedging mechanism for passive long portfolios can face a challenging hedging environment when declining equity markets are in extended Transition VIX stages – grinding down slowly without the VIX move above 35 which generally announces Crisis VIX and potentially offers the most potent hedge.
As we have noted earlier, Crisis VIX levels typically occur during Secular Crises when systemic risk of recession gets priced into the overall market – usually after the collapse of market breadth leaves traders few diversification options and significantly increases the rationale for systemic put-hedging.
As illustrated in the chart below, one of the measures of market breadth – the percentage of stocks outperforming the S&P 500 index – is at two decades lows:
In addition to extreme concentration of stocks, the inversion of the Treasury yield curve has in the past supported the probability of recessionary outcomes for the economy as a whole:
There may not be any reason to believe that this current 2023 yield curve inversion will be any different from those in the past, particularly in the stagflation decade of 1970’s when inflationary expectations were so high that the FED’s rising interest rates lowered output and employment rather than capping prices – and led to three yield curve inversions and three recessions before inflation was ultimately tamed. We believe that the FED’s current determination to stifle inflationary expectations is one of the leading reasons that the FED will continue to be hawkish well into a hard-landing recession, if necessary.
For these and other reasons, Little Harbor Advisors would suggest that a systemic market hedge is more prudent than ever. The Transition VIX of the last year may, as it has in the past, mark a topping process in the S&P 500 and a gateway to an impending crisis – as the reality of a looming recession undermines the narrow group of large market capitalization stocks upholding the current market, and as market participants realize that the FED is effectively short the S&P 500 until inflation is under firm control.
Disclaimer
The information in this presentation is for general information purposes only. Little Harbor Advisors makes no representation or warranty, express or implied. You should not construe any such information or other material as legal, tax, investment, financial, or other advice. Nothing contained in this presentation constitutes a solicitation, recommendation, endorsement, or offer by Little Harbor Advisors or any third-party service provider to buy or sell any securities or other financial instruments in this or in in any other jurisdiction in which such solicitation or offer would be unlawful under the securities laws of such jurisdiction.
[1] S&P 500 Index is the S&P 500 (TR) Index and VIX is Chicago Board Options Exchange (CBOE) Volatility Index.
[2] The VIX measures expectations for stock market volatility over the next 30 days by using options data in combination with other factors such as volume data and open interest index data in order to compute a value. Increase in S&P puts relative to S&P calls increases VIX.