MAINIA
“AI” mania powered the Nasdaq 100 index (+7.6% May) to a 1-year high in May as a small group of mega cap tech stocks kept the S&P 500 (+0.4% May) afloat while leaving the broader Russell 2000 index (-0.9% May) and foreign equities (MSCI EAFE -4.2% May) struggling under the weight of slowing growth and a recession in Germany.
YTD Return Comparison. Source: Yahoo Finance. Click for larger image
The move marked an extension of the modern-day “flight to quality” since the failure of Silicon Valley Bank that has concentrated massive market influence into a handful of tech giants including Apple (AAPL), Alphabet Inc. (GOOG, GOOGL) and Microsoft (MSFT) which now comprise a stunning one-third of the entire Nasdaq 100 index and nearly a fifth of the S&P 500. While it supports indexes on the way up, this distortion can also work in reverse and with Apple now larger than the entire Russell 2000 index, markets have become more reliant than ever on this theme.
As sector rotation has so far kept a lid on index volatility in 2023, VIX headwinds from the options market have been abating as both “skew” (the price of puts relative to calls) and the price of tail protection have quietly reversed much of last year’s weakness, setting up better potential for VIX movement once conditions change (see chart below).
Nations SkewDex and TailDex Indexes, 2020-2023. Source: Nations.com. Click for larger image
In our view, the bond market remains the most likely catalyst for this change, first from the substantial liquidity headwind following the resolution of the “debt ceiling” stalemate and later this year when expected rate cuts in the fall carry significant potential for equity markets, whether they are the bullish preemptive type or are made in response to a market crisis (see chart below). Especially under such fluid conditions, flexibility will likely be key for investors.
Average S&P 500 performance following rate cuts. Source: Macrobond. Click for larger image
Doing Hard Things
To avoid being average requires doing things that most aren’t willing to do and for TCM strategies, this means embracing the unique tradeoffs of using VIX exposures as a primary hedge. Whereas typical protection is predictably anchored to discreet price levels, VIX prices move with the perception of risk which while often untethered in a crisis, can be counterintuitive in some situations.
Trailing 1 Year Return History 2005-2021, S&P 500 and VIXY (SPVIXSTR Index). Source: Yahoo Finance, TCM. Click for larger image.
Though the perception of risk does not commonly decline in a falling market, this outcome was observed before 2022 with VIX futures and the S&P 500 declining together in about 5% of all 12-month periods between 2005 and 2021 (see chart). Of course, by definition, rare outcomes do not often repeat and in all 228 of these instances, the typical inverse VIX / S&P relationship was observed in the subsequent year.
Despite travelling through this rarest and least favorable environment, hedging expense for Tactical Beta in the year through May has been less than 8%, a figure only slightly below the strategy’s historical median since inception and one that compares favorably to the median outcome for options strategies that have only recently been seeing some success relative to the S&P 500. What’s more, if markets are on the cusp of a new bull market as some believe, the hedging drag of options strategies is almost certain to increase going forward, while the Tactical Beta approach moves to reduce or eliminate it altogether.
1-Year Relative Return Ranges, Oct 2017-May 2023. Source: Yahoo Finance, TCM. Click for larger image
Of course, historical investment results reflect only a manager’s decisions. In real time, an investor’s results depend just as much on his or her decisions outside of a portfolio as on the manager’s decisions inside of it. Like working with a doctor, investing is best understood as a collaborative effort between an advisor and a client who attempt to address complex issues with imperfect information in an iterative process of learning and adapting. With the right perspective, the right tools and a little patience, many have found this process to ultimately be worthwhile.