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. 

September 2018 Commentary

Hurricane Season

Markets largely hung around the flat line in September in an apparent standoff between benign economic data and negative trade headlines.  Like previous episodes this year, the negative reactions proved to be sharp and short, causing a brief flash of caution from our dashboard in the early part of the month.  Otherwise, it was a quiet few weeks from both a market and trading perspective.     

Surveying today’s volatility landscape, we can currently identify a few potential candidates for “spikes” (small Vol Loops) as well as for more substantial “swells” (large loops).  Examples of each are below.

Likely candidates for short-term spikes include news flow around US mid-term elections, trade (tariffs) and the Mueller investigation.  As with any spike, each of these has the possibility of being quickly diffused or snowballing into something more serious for markets (what we term a volatility “swell”).  Of course, it is impossible to know ahead of time which route these will take, so we will continue to stay focused on monitoring changes in the volatility market to guide the best course of action.

Slower-moving but larger “swell” catalysts include the ongoing rate hike cycle and European budgetary issues centered around Italy.  In contrast to the spike candidates mentioned above, a strong link to financial system health and a lack of well-defined outcomes or expiration dates give these issues greater potential for sustained volatility.  Much like preparing for a hurricane, investors would do well to construct a survival plan in advance.

August 2018 Commentary

The Fed and Market Indigestion

In a move that would typically provoke double-digit responses, the S&P 500’s +3.3% jump in August barely registered for VIX ETPs that are the “raw material” for Alpha Seeker as it seeks out trends in these instruments.  Surveying similar action on the year as a whole, 2018 is now beginning to recall memories of the turn in the last major VIX loop in 2007.

Much like this year, the early 2007 VIX low was followed by a shock in February which resulted in a new, higher floor for VIX even as the S&P 500 went on to make new highs in the fall.  Then as now, the trendless but volatile VIX environment was a challenge for Alpha Seeker which recorded the only negative year in its backtest in 2007.  Neatly fitting our Vol Loops thesis, this was then followed in 2008 by the simulation’s best year.  It is also notable that the largest long VIX ETP (ticker VXX) is still positive on the year as of August for just the third time in the index’s 14-year history and second only to… August 2007. 

In our experience this type of VIX action is an indication that the market is wrestling with big issues, and it is perhaps no coincidence that it is occurring three years into the first rate-hike cycle since 2004 – 2006.  In a world economy saturated with record debt at all levels, it is reasonable to expect the credit cycle led by the Fed to continue to be the major factor for asset prices and volatility.  Whatever course the market takes after its “indigestion” ends, we will continue to take our cues from the dashboard rather than any predictions.