September 2020 Commentary

SPECULATIVE UNWIND KEEPS VIX upside-down

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Sept 2020 return comparison. Click for larger image

Continuing the streak of positive correlation that began in mid-August, the VIX and stocks fell together in September, creating a drag from hedging positions that were added early in the month in Smart Index, Smart Tech and Legacy Navigator. Benefitting from its focus on long and short S&P positions, Alpha Seeker notched its 3rd consecutive positive month and has now doubled the S&P 500 on the year with just 0.29 daily correlation.

POSITIVELY INCLINED

Normally, the demand for insurance exceeds the demand for lottery tickets. In finance this shows up in the “skew” of option prices towards put options that normally make them dominant factor in determining the level of the VIX. When demand for options is skewed toward protection (puts), the VIX Index (the demand for put options) rises as the market falls, and vice versa.

Mirroring the persistent skew toward puts after the market crash in 1987, the daily correlation of the VIX Index with the S&P 500 since 1990 is -0.70, a strong but not perfectly inverse relationship. Positive VIX/S&P correlation can occur when option demand shifts strongly toward calls, typically around speculative peaks like the massive one we’ve seen in recent weeks (see chart below).

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Small Trader Option Premium vs S&P 500. Source: @SentimentTrader. Click for larger image.

During these periods, the VIX Index can be “upside-down”, driven by the demand for calls (lottery tickets) rather than puts (insurance). As the speculation peaks and demand shifts back towards put options, the VIX/S&P relationship then normalizes. For more information, see Matt’s appearance on a recent podcast as well as his contribution to this Bloomberg article.

Like so many things in markets, this is a naturally cyclical process driven by human emotion. As this cycle plays out, we will continue to be guided by the “Holy Grail” of investing:

August 2020 Commentary

VIX STILL fighting the equity mania

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5 Day Correlation: VIX Index and S&P 500 Index. Click for larger image

Riding on the back of continued gains in equity indexes, TCM strategies were all substantially higher in August. The mania in tech names in particular has become reminiscent of the late 90s, boosting our Smart Tech strategy by nearly 30% since May and over 10% in August alone. Curiously, late in the month the VIX index began rising alongside equity markets, bucking the normal inverse relationship and suggesting discomfort with the market’s torrid pace or perhaps growing apprehension over the coming US Presidential Election.

Money Games

While those fortunate enough to own assets celebrate their nominal gains, we are reminded of a college party where guests played games to earn play “dollars” that could be used to bid on such coveted prizes as a gift certificate to the local Chili’s. While the preoccupation among starving students was with competition in the game room, in reality the real action was in the money room.

When vying for resources with ring-toss and dart skills proved tedious, new money began to find its way into the hands of the organizers near the vault upstairs- slowly at first, then growing increasingly bold as the night wore on. While obscene sums began to be exchanged for increasingly questionable “games” upstairs, activity in the downstairs economy dwindled as hours of game earnings now barely registered on the bid sheet. With the best prizes impossibly out of reach, participants focused on buying the items they could as their prices also steadily rose, all the while marveling at the vast resources of the organizers upstairs, never understanding the real game.

While stock prices soar as the Fed prints and funnels trillions to mega-cap tech companies through its bond purchases, it is important to keep in mind that every new dollar is also a new claim on society’s resources. Similar to a stock split, manipulating the value of the dollar is an accounting maneuver that creates an illusion of wealth, with real costs for everyone and true benefits for only a select few. If the market ever comes to this realization, the adjustment could be dramatic; investors today would be wise to have a plan.

July 2020 Commentary

HOW THE OTHER 99% Lives

Building on solid year-to-date gains, TCM strategies all performed well in July as the VIX marketplace sent a clearer message of normalization throughout the month. With stocks now positive on the year despite a stunning -32.9% annualized contraction of the economy in Q2 (more on this below), it is perhaps little wonder why the VIX remains stubbornly elevated and yet to trade below 20 since mid-February.

Due in large part to the popular market-cap weighting methodology, the gap between equity index performance and economic reality continues to widen. As smaller “brick and mortar” companies shrink in the face of the worst fundamentals in decades (23 retail bankruptcies this year alone), a handful of mega-cap tech names have seen valuations explode due to their perceived immunity to the economic shutdown. As a result, indexes have become increasingly concentrated. Indeed, the 5 largest names in the S&P 500 (all tech) now represent a record 23% of the index and have accounted for substantially all of the S&P 500’s return in 2020 and over the past decade (see images below).

Like it or not, the fate of the market now rests largely on these 5 names. For now, indexes are content to ride their coattails higher, but it remains to be seen how long the struggle of the other 99% can be swept under the rug. Entering the worst seasonal period for stocks with these mega-cap tech names facing increasing antitrust pressure and less than 100 days from a pivotal presidential election, a return to normal volatility may still be a ways off.

June 2020 Commentary

walk the line

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S&P 500 and VIX YTD 2020. Click for larger image.

Reeling from a violent selloff that saw the S&P 500 drop nearly 6% on June 11, equities still managed to stagger to a positive month in June as the continued outperformance of the technology-heavy Nasdaq 100 index boosted our new Smart Tech strategy once again.

Despite an impressive rally in equities since the March lows, the message from the VIX continues to be one of uncertainty and caution as the widening gap between equity prices and economic reality has kept hedging markets on edge. An unusual occurrence, markets have now staged a 3-month winning streak with the VIX Index remaining mostly over 30. It appears that the “Gladiator Match” between liquidity and solvency will be ferocious at the scrimmage line of the unchanged mark on the year for equities.

While common around critical junctures, this “difference of opinion” between stocks and hedging markets creates a challenging environment for strategies that respond to the message from the VIX. As a case in point, long and short VIX positions (the two positioning options for Alpha Seeker) have both been unprofitable in the hesitancy since May (bottom panel on image above). While this condition persists, hedging positions in Smart Index are relatively cheap but have yet to see the volatility from stocks that would move them meaningfully higher.

Through many market phases over the past decade, TCM strategies have produced their top-ranking results by a consistent application of our process, not by consistently “out trading” the market. Especially with the enormous range of possible outcomes stemming from the largest economic shock of our lifetimes, we believe that prudent risk management is paramount.

May 2020 Commentary

HARDly Normal

Even as the S&P 500 clawed another 4.8% out of the Coronavirus hole in May, VIX futures hovered near crisis levels throughout the month, indicative of the uncertainty around the ongoing “gladiator match” between liquidity and solvency. While the VIX has retreated from outright panic after the stock market rally of the past two months, its message today is that things are “hardly normal”:

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S&P 500 and VIX Futures, YTD 2020. Source: TCM, Yahoo Finance

Follow the leader

By now, long-time readers should be prepared for a familiar line: following the message from the VIX, TCM strategies performed in line with markets in May with a neutral VIX having little impact during the month. With the largest exposure to the S&P 500 of our three strategies, Smart Index (+4.5%) predictably fared the best in May, followed by the more-diversified Legacy Navigator (+3.4%) and finally by Alpha Seeker which remained flat with the broader VIX market.

With the economic fallout from the Coronavirus pandemic now compounded by civil unrest just a few months before a presidential election, it’s no wonder that the entire VIX complex remains elevated. Especially as these issues come to a head this fall, investors need to be prepared for anything.