February 2019 Commentary

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The S&P 500 is testing its broken post-2009 trend

Now What?

“Kick the can” is the favorite game of politicians confronted with a difficult decision such as extending the debt ceiling or negotiating an exit from the EU.  In markets, this stall tactic typically acts to suppress near-term volatility expectations relative to those in the future, resulting in a steep upward slope in the VIX futures curve that signals our strategies to turn more aggressive.

With its abrupt dovish pivot in January, the Fed engineered perhaps the greatest can kick in VIX futures history, simultaneously suppressing volatility expectations at every time frame and flattening the entire VIX futures curve in just a matter of days.  With its stubborn refusal to steepen even after the vertical S&P move and precipitous fall in VIX over the past few weeks, our system continues to signal caution. 

At time frames longer than the last eight weeks, a cautious stance begins to make more sense.  Even after one of its most explosive rallies in history, the S&P 500 index remains 5% below the all-time high set 6 months ago, stalled at its broken bull-market trend dating back to the lows in 2009 (see chart above) and almost exactly where it stood a year earlier.  In the intervening period, the index has entered and then partly recovered from a bear market as growth continues to slow in the US and abroad.  Despite this, after a few soothing words from the Fed, the VIX is suddenly implying not just some near-term stabilization, but smooth sailing the rest of the year.  Only time will tell how far the can has really been kicked.          

From FOBI to FOMO and In Between

With the crash phase neatly accruing to last year’s number, the YTD rally in equities appears all the more impressive and has quickly turned 2018’s “Fear Of Being Invested” (FOBI) to 2019’s “Fear Of Missing Out” (FOMO). 

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Past performance is not indicative of future results. Smart Index and Alpha Seeker returns from sample accounts, net of 1% fee.

A common symptom of FOMO, there appears to be selective amnesia regarding what has been “missed” in the S&P 500 over the last 6 months:

• Cumulative loss of 3%

• Above-average volatility

• Bear market (20% drawdown)

Not without their own challenges over this brief period, our strategies have nonetheless managed to substantially improve on the passive indexing approach that has become popular during the market’s nearly uninterrupted rise over the past 9 years.  If the recent past is any guide, it may be time to reconsider the benefits of investment strategy diversification. 

January 2019 Commentary

From Panic Selling to Panic Buying

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Past performance is not indicative of future results. Smart Index and Alpha Seeker sample accounts, net of 1% fee

January’s about-face from the Fed was enough to lift the S&P 500 from its worst December since the Great Depression to its best January in 30 years.  Given this extreme movement, the VIX complex never fully normalized in January, even as the S&P recouped a large portion of December’s losses.  In the end, Alpha Seeker finished the month modestly lower while Smart Index rose with the market after abandoning hedges early in the month.   

Despite January’s excitement, the wild ride of the past two months has amounted to a -1.7% loss for the S&P 500, while Smart Index is roughly flat and Alpha Seeker has managed a gain of +2%.

Fight Volatility With Volatility

Time and again, turbulent market periods highlight the need for a volatility “buffer”,  especially inside portfolios with significant exposure to equity indexes.  Such a buffer not only reduces the risk of costly emotional reactions, it can actually lead to better outcomes over time.  In other words: even a small allocation to the right non-correlated exposure can make an investor’s experience both less stressful and more profitable. 

For example, in the period between Oct 2018 and Jan 2019, adding 10% Alpha Seeker to a standard 60/40 balanced portfolio improved return, lowered volatility and reduced the maximum monthly drawdown- even during a period when Alpha Seeker returned a small loss.  

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Past performance is not indicative of future results. Hypothetical portfolios, rebalanced monthly. Alpha Seeker returns from sample account, net of 1% fee

When reviewing Alpha Seeker’s entire track record of consistent positive annual returns, the same 10% allocation has provided a substantial return or volatility improvement over a standard 60/40 balanced portfolio in each of the past 7 years.     

With economic and political uncertainty on the rise after several years of relative calm, now more than ever investors need to take steps to manage risk in their portfolios. Nobody knows what the future holds, but with the right tools, advisors and their clients can be better prepared for whatever lays ahead.    

December 2018 Commentary

Past performance is not indicative of future results. Alpha Seeker and Smart Index returns from sample accounts, net of 1% fee.

A December to Remember

For the first time in the nearly 100-year history of the S&P 500, December became the worst month of the year for stocks in 2018 as the S&P 500 shed -9% after sliding to nearly -15% MTD on Christmas eve.  A far cry from the double-digit YTD pace in October, a brutal 4th quarter dragged the stocks into the red for the year with the S&P 500 slipping -4.4% in 2018.

The VIX reaction was again relatively muted, but sufficient enough for Alpha Seeker to post its best month of the year in December and for Smart Index to add 400 basis points to its already substantial YTD lead over the S&P.  Both strategies finished 2018 with single-digit gains. 

When Nothing Works

The appealing logic of low-cost exposure to the long-term upward trend in stock markets continues to attract billions of dollars to indexing strategies.  While the merits are clear during strong markets like we’ve seen in recent years, cracks begin to show when indexes falter and the “long term” view takes a back seat to “do something” about short-term realities. 

In liquidation periods like this year when EVERY index struggles, portfolios can be insulated from the risk of costly emotional decisions with an exposure that does not depend on rising asset prices.  Volatility strategies can fit the bill, but unless they are flexible and can adapt to the current market environment they may actually increase risk and fail to provide the desired insulating effect.  Our strategies were designed with this in mind and we’re excited to continue demonstrating their value for our clients in the years to come.     

November 2018 Commentary

Past performance is not indicative of future results. Smart Index and Alpha Seeker returns from sample accounts, before fees.

a plethora of political potholes

The roller coaster ride continued for markets in November, with several “rips and dips” on headlines around mid-term elections, the trade war with China and a possible softening in the Fed’s hawkish posture on rates.  Though a late rally managed to lift the S&P 500 into the green on the month, the index remains mired below September’s all-time high having twice dipped into the red for 2018 in recent weeks. 

As investors came around to the idea of sustained weakness in equities, the more logical VIX reactions to S&P moves in November helped produce the outcomes we set out to achieve with our strategies.  We were pleased to see Alpha Seeker’s low (14%) daily correlation to the S&P and a reduction in intra-month drawdowns relative to the S&P 500 for both strategies. 

A Fed “pause”: be careful what you wish for

The late-November rally in stocks was sparked by a speech in which Fed Chair Jerome Powell hinted that a pause in its rate hike cycle might be closer than markets had previously believed.  Looking past the knee-jerk reaction, history suggests that Fed pauses have historically happened around recessions and tops in equities.  Rather than an excuse to “keep the party going”, an end to rate hikes is a sign that the Fed no longer views the economy as healthy enough to handle higher interest rates.  Once this belief takes hold among CEOs and investors, it can become a self-fulfilling prophecy.   

 After a near decade-long hiatus, in our view this is now the single most important factor for markets and one that we will be monitoring closely.  While recessions and bear markets will certainly cause headaches for passive strategies, they present a substantial opportunity for tactical approaches like ours. 

October 2018 Commentary

VIX yawns while stocks crumble

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S&P 500 vs VIX Index, Oct 2018. Click for larger image

Defensive positioning in Kaizen portfolios is determined by signals from the VIX market as interpreted by its Vol Dashboard  .  Standing in sharp contrast to the experience in February this year when signs of stress appeared before and during the plunge in equities, a remarkably placid VIX in the face of October’s rout led to hesitation in the deployment of defensive (long volatility) positions and once applied, blunted their effectiveness. 

Over a decade of trading volatility products we’ve seen the VIX be flat-footed on a few occasions, but its inability to trade over 30 during a 10% decline in stocks is historically unusual and suggests complacency.   

A Question of Balance

After every substantial market move, there is a natural obsession with stories of sensational gains (or losses) generated by the most aggressive approaches.  They may generate website clicks, but unbalanced strategies do not succeed in creating value over time.   This is especially true for VIX strategies where these approaches (short-only or long-only) have a dismal track record:

Our approach is simple: take positioning cues from the VIX and keep portfolio risk in line with the market.  We’re under no illusion that this is a perfect science- and with proper risk control, it doesn’t need to be. For example, Alpha Seeker has outpaced the S&P 500 and static VIX approaches with just 45% winning days since inception and even when hindered by this month’s VIX hesitation, limited October’s peak drawdown to 1/3rd less than the S&P 500’s.  With similar statistics on its VIX positions, Smart Index is ahead of the S&P 500 in a challenging year with negative down capture since its inception in 2016. 

Now and Next

October’s drama has jolted the S&P 500 from its sleep and dragged it to right up to the line that divides bull and bear markets.  As we saw this month, these periods present risk and just as importantly, substantial opportunity for our approach.  If a new bear market is upon us, then based on history it is reasonable to expect a 30-50% decline in the S&P over the coming months accompanied by a sustained rise in the VIX well beyond its current level around 20.  If instead this is just another correction in the bull market since  ‘09, a return to normal volatility would see the VIX fall 40-50% from October’s close, significantly boosting the prices of inverse VIX products. 

This is not to suggest that the path ahead will be easy: after all, high volatility literally means increased uncertainty and dispersion in outcomes.  It might not be possible to profit from high volatility in a low volatility way, but with the proper tools we can use it to our clients’ ultimate advantage.