September 2019 Commentary

ROUND AND ROUND WE GO

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Vol Loop progression, Sept 2019. Click for larger image

In a familiar refrain, an early burst of optimism around rate cuts and US-China trade talks fizzled throughout September as the S&P 500 faded and the VIX Index strengthened in the back half of the month.  In the end, stocks were modestly higher, though still little-changed since July 4th, over the past year and since Jan 2018 highs over 20 months ago. 

Despite its late rise, the VIX index remained in the “green zone” under 18 for most of the month.  In this zone, VIX products are usually overpriced as they anticipate a rise in volatility that is slow to materialize (see image at left).  Following the VIX “Rule of Thumb” laid out in our August commentary, TCM strategies all showed a profit in September, by either avoiding (Smart Index, Legacy Navigator) or betting against (Alpha Seeker) these overpriced contracts. 

ZONE DEFENSE

At the most fundamental level, our process is like any other investment; buy cheap assets and sell expensive ones.  We focus on VIX contracts because of their value proposition is uniquely quantifiable– they are tied to an index (the VIX Index) that just spins in a closed loop, from low to high and back again.  Based on this concept, we created a dashboard to help us identify when VIX contracts are mispriced so we can buy them cheap and sell them dear.  

Now comes the tricky part: it is not possible to own the VIX Index itself.  Exposure can only be gained through VIX futures (or ETFs & options based on them).  These contracts are basically guesses of where VIX will be in the future, so they are usually priced much differently than the VIX Index itself until just before expiration.  Put it all together and it turns out that “value” for VIX contracts tends to be inversely correlated with the level of the VIX Index: when the VIX Index is low, VIX contracts often become overpriced and vice versa. 

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VIX Zones vs S&P 500 Behavior. Source: TCM. Click for larger image.

This sets up a curious situation.  Since VIX inception in 1990, all of the S&P 500’s cumulative gain has come on days when VIX closed below 18 (see chart above).  In other words, while the VIX is low and VIX contracts are most expensive, protection is not really needed anyway!  On the other hand, the S&P has shown a cumulative loss on all days when VIX closed over 20-  when VIX contracts are “cheapest” to own!  In essence, VIX contracts pay investors to align with the current trend in VIX, either higher (in the “bear market zone”) or lower (in the “bull market zone”). 

This is why our approach is usually to bet against VIX contracts when the VIX index is low (say, below 18) and bet with them when VIX is high (say, over 20).  In between, when VIX contracts are around fair value our approach moves to the sidelines, dipping its toes in the water as VIX starts to move outside the transition zone, in either direction.   What we end up with are strategies that perform best at either end of the spectrum (in bull or bear markets) and tend to churn with the market during transitions.  This profile may not be a “bad day preventer”, but it is a very cost-efficient way to blunt the impact of bear markets on portfolios.    

It can be frustrating while markets churn but when investing, impatience is seldom rewarded. It is precisely during these periods when advisors provide real value by maintaining discipline necessary for clients to reach their long-term goals.     

August 2019 Commentary

MARKETS TOSSED ABOUT BY TRADE TWEETS

The “Trade War Cycle”. Credit: Macro Risk Advisors

After the latest escalation in the US/China trade dispute, markets were sloppy in August, churning violently in a 3.5% range with a majority of days in the month moving more than 1% in either direction.  Echoing the broader pattern at play since 2018, the end result was strained nerves and a modestly lower stock market. 

Also conforming to the post-2018 pattern, August’s tension without resolution held the VIX index in the 18-20 “transition zone” for the entire month, an area which has historically provided little edge for either long or short VIX positions (more on this below).  As a result, TCM strategies performed broadly in-line with the market.  

The overall picture remains one in which the equity market spins in the trade war cycle (see image above) while underlying fundamentals slowly deteriorate and bond yields collapse.  With another rate cut expected at the September Fed meeting, we may soon know whether even lower rates are “just what the doctor ordered” or “too little too late”. 

DECK CHAIRS AND LIFE RAFTS

After the tax cut sugar high in Jan 2018, softening data and an increasingly erratic administration in Washington have given equity markets a nasty case of indigestion.  Over those 19 months and counting, the S&P 500 has been caught in a box, declining -0.2% while the VIX index has exceeded 20 (its long-term average) at a pace last seen in the run up to the 2008 Financial Crisis. (click chart below to enlarge) 

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Similar to 2007, the S&P has been caught in a “box” while VIX has increasingly tested 20. Click for larger image.

The message from other markets is no better, as gold and bonds have massively outpaced equities which themselves have been buoyed by late-cycle sectors such as utilities, real estate and consumer staples.  After two straight quarters of declining year-over-year S&P 500 earnings, US manufacturing in contraction and the Treasury yield curve inverted in the classic recession indicator (also the first time since 2007), it is perhaps no wonder that corporate insider sales are at a high last seen in— you guessed it— 2007. 

The tension of this environment has even been persistent enough to impact the normal relationship between expected and realized volatility known as the “volatility risk premium” (VRP).  Used by many strategies including Alpha Seeker as a source of return, during bull markets VRP tends to be consistently positive as investors anticipate a rise in volatility that is slow to materialize.  In bear markets, the opposite is true.  In consolidating markets like the one since 2018, VRP is often marginal as expectations for increased volatility are frequently met or exceeded.  In this environment, it is common to see VRP strategies consolidate along with equity markets, as evidenced by the stalling of option-selling strategies (CBOE PutWrite Index), inverse VIX ETPs (SVXY, ZIV) and Alpha Seeker since Feb 2018.  Like bull and bear phases in equities, VRP moves in cycles and its recent behavior is suggestive of a major turn ahead for markets.   

There is no system for anticipating 2am tweets that instantly turn the world upside-down.  There is, however, historical precedent for periods of equity consolidation with a vanishing volatility risk premium and VIX percolating under 20.  Not all have ended with bear markets, but many have.  To borrow an old trading phrase, investors increasing beta or crowding into bonds at this juncture may only be “rearranging deck chairs on the Titanic” and could be left without a life raft when they need it most.  Savvy investors understand that time to start thinking outside the box is while we’re still in it.

THEORY OF RELATIVITY

At TCM, our fundamental risk management philosophy is to own protection with VIX exposure only when it is underpriced. (Taking this one step further, Alpha Seeker also plays offense by selling VIX exposure when it is overpriced).  Using our Volatility Dashboard, the “value” of VIX exposure is continuously assessed by comparing volatility expectations across various time frames. With this process, value in VIX is always a relative concept and tends to have an inverse correlation with the level of the VIX.  While not an explicit input for our system, the level of the VIX can be used as a rule of thumb for anticipating its likely positioning. 

In general, TCM strategies:

• Increase VIX / reduce S&P 500 exposure while the VIX index is above 20

• Reduce VIX / increase S&P 500 exposure while the VIX index is below 18

In the zone between 18 and 20, choppy portfolios and small back-and-forth trades are common as the dashboard looks for signs of a break in either direction.  Especially in this zone, the goal with any trade is not a high win-rate, but rather high risk-reward.  In other words, the system focuses on positioning portfolios for a substantial move out of the transition zone, even if it must scrap several trades in the process.  This results in strategies that cover both ends of the volatility spectrum well, participating in bull markets while avoiding, cushioning or profiting from true bear markets.

With this framework, the experience during the congestion of the last 19 months comes into clearer focus.  Since 2018, the VIX has returned repeatedly to the transition zone while refusing to settle decisively below 18 (as in bull markets) or over 20 (as in bear markets).  Following the rule of thumb, during this period Alpha Seeker showed an cumulative profit both while the VIX was below 18 and while it was above 25, offset by paper cuts from the transition zone chop.  Due to its cumulative hedging profits in the “high VIX” zone, during the same period Smart Index has outperformed the S&P 500 with lower volatility and drawdowns. 

In the context of a consolidating market primed for a substantial break in either direction, this should be extremely encouraging– a quick look at the two ends of this spectrum explains why (click chart below to enlarge). After 2016’s 18-month consolidation finally broke to the upside in 2017, Alpha Seeker returned 24% with lower volatility than stocks, while Smart Index was true to its name and matched the index’s strong return that year.  On the other hand, after 2007’s market consolidation devolved into the Financial Crisis of 2008, Alpha Seeker showed the strongest yearly gain in its backtest (41%), while the Smart Index backtest largely sidestepped the entire drop and was flat on the year.

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2008 results for Alpha Seeker and Smart Index are hypothetical. Click for larger image.

For those who prefer to avoid using hypothetical performance, it can be observed that:

1. Since inception, Alpha Seeker has posted a cumulative gain for all days when VIX closed over 25. 

2. Since its inception in 1990, the VIX index has averaged over 25 in every year that the S&P 500 declined 10% or more.  (2000, 2001, 2002, 2008)

Of course, the next bear market will not look exactly like any that have occurred before- but this unknown element is precisely why volatility and the VIX index become elevated. In these periods, the ability to use that uncertainty to mitigate risk can make all the difference for a portfolio.

Legacy Navigator Allocation Update

In response to a deteriorating technical picture, the allocation to MSCI EAFE (Developed Ex-US) equities in our Legacy Navigator portfolio has been replaced by fixed income exposure across 7-10 Year US Treasuries (IEF), High Yield Bonds (ANGL) and US “Low Volatility” equities (USMV). (Owing to their substantial exposure to interest-rate sensitive sectors such as utilities and real estate, “Low Volatility” equities often have high correlation with fixed income.)

This follows a similar move with Emerging Market equities earlier in the year and is broadly reflective of the weakening global growth environment. Should this condition persist, defensive exposures such as fixed income and Alpha Seeker will likely benefit relative to growth- or beta-oriented positions. Over a decade since the last global recession, we may soon see how many of today’s investors have forgotten the lessons of history. Click chart below to enlarge

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Legacy Navigator allocation as of 8/19/19

July 2019 Commentary

STEEPEST VIX CURVE OF 2019 LIFTS ALPHA SEEKER PAST S&P IN JULY

Led by Alpha Seeker, all three TCM strategies posted strong returns in July as markets seemed to be on autopilot ahead of a widely-expected rate cut at the 7/31 Fed meeting.

2nd VIX future daily settlement / 1st VIX future daily settlement, 20 day average. Source TCM

One of the most important metrics in our Vol Dashboard, the steepness of the VIX futures curve (the difference between the prices of the first and second VIX futures) is an excellent indication of the strength and magnitude of the recent trend in the VIX.  In contrast to its stubborn flatness in Q1 while recovering from 2018’s end-of-year shock, since late March the VIX curve has returned to its more typical upward slope– the signature of a solid trend lower in VIX and a constructive environment for Alpha Seeker.  While risk assets in general also tend to do well during such periods, Alpha Seeker is set apart by its ability to profit in much the same from a steeply inverted VIX curve during stressed markets when risk assets are often declining.  This feature is easy to overlook while markets are rising.  On the day when there are no rising assets left to chase, its benefit will be invaluable.

FINDING YOUR BALANCE

Conceptually, an investment’s return is simply the result of its capture of the “ups” and “downs” of the market over a given period.  Over time, a portfolio is optimized by finding the mix of “up-capture” and “down-capture” appropriate for an investor’s risk tolerance while considering the full range of likely outcomes over a market cycle. 

Many investors assume that beating the market requires maximizing up-capture while stomaching the resulting volatility (down-capture). Recently, others have taken the opposite approach, advocating low volatility (reduced up- and down-capture) as the next “holy grail”.  As usual, the actual solution is more complicated than a single factor and does not lend itself well to the short attention spans of today’s typical investor.

Hypothetical growth of $1000 using historical capture ratios applied monthly to S&P 500. Source: TCM

Rather than a “bad day preventer”, the system at Thompson Cap was designed with entire market cycles in mind, seeking to produce a mix of up- and down-capture that leads to better outcomes over time.  While the ratios produced by Alpha Seeker and Smart Index have led to superior results in the few years since inception, the potential becomes even more compelling as the time frame is extended.  Applying historical capture ratios to past monthly returns of the S&P 500, the chart above compares theoretical outcomes of Alpha Seeker and Smart Index with the S&P 500 Low Volatility Index and an “aggressive” (1.2 Beta) equity portfolio over the two market cycles since 2000.  No strategy will be perfectly consistent, but the potential of even a slight improvement in risk management is obvious if only investors would choose not to surrender it.     

Alpha Seeker Roster Update

We’ve recently added two new tickers to the menu of available “long VIX” positions in Alpha Seeker: SH (ProShares Short S&P 500) and SDS (ProShares UltraShort S&P 500).   

Similar to the addition of UPRO and SPXL on the “short VIX” side, SH and SDS have very high correlation to long VIX exposures and will allow Alpha Seeker to better address the occasional lags between S&P and VIX performance.  As always, the ultimate goal is to improve outcomes. 

Please feel free to contact us with any questions.

Alpha Seeker Roster, Aug 2019