May 2019 Commentary

VIX UNMOVED BY S&P’S WORST MAY SINCE 2010

May’s VIX high was reached well before the S&P 500 low

With the VIX sending few distress signals, Smart Index and Legacy Navigator saw index-like declines in May while Alpha Seeker’s lighter exposure kept losses in check relative to the equity markets. 

Reflecting an oddly disinterested options market, the VIX barely registered a pulse in May despite a series of overnight gaps that were responsible for substantially all of the S&P 500’s decline on the month.  Tepid moves and several strong reversals during regular trading hours kept a lid on any panic, with the VIX index only briefly breaking 20 around its peak on May 9th.  For now, distress signals appear to be coming mainly from the bond market, with collapsing Treasury yields leaving much of the curve inverted in a classic recession signal. 

All in all, the situation today bears resemblances to previous equity market tops as participants initially discount any warning signs only to over-react as the new reality becomes more widely accepted.  Rather than an event, this is a process that often takes months as it produces a signature of increasingly erratic and trendless equity markets.  Especially during this time, basing expectations on recent bull-market performance puts investors at substantial risk of disappointment.

This May Hurt A Bit

Grey shaded figures are hypothetical. Past performance is not indicative of future results.

From a business perspective, financial advisors have a lot in common with doctors.  Both use technology and experience to make decisions based on probabilities in the face of imperfect information.  Perhaps most importantly, outcomes in both fields are the result of a team effort: a doctor prescribes a therapy, but the patient must choose to see it through.  On paper, the choice is easy- until the physical and psychological discomfort of treatment stands in the way of the patient’s long-term health.  And so the search for a miracle cure or more cooperative doctor continues as the patient’s health deteriorates.   

Bringing the analogy closer to home, a “patient” looking for a repeat of Alpha Seeker’s 63% gross year in 2012 must be prepared to swallow the pill of a 14% drawdown and five months trailing the S&P 500 by an average of -5.5%.  Similarly, exposure to the strategy’s hypothetical 42% gross return during 2008’s bear market required enduring the discomfort of a loss in each month of Q1, an unremarkable +0.1% gross YTD return through June and 33 days of 2% or worse losses.  Figures for US Equity Smart Index tell a similar message (see table at right), as do the stats for just about every equity-like investment on the planet.

Every investor will eventually face discouragement.  After all, investing is a complex challenge involving ever-changing information and human emotion– there are no easy answers or foolproof rules.  As with medicine, responding successfully to the challenge is a team effort requiring a mix of experience, skill and at times, grit.  

April 2019 Commentary

AS STOCKS COMPLETE 7-MONTH ROUND TRIP, YIELDS CONTINUE TO CRUMBLE

Treasury yields have diverged from stock prices in 2019

Each of our strategies posted a solid month in April as another push higher returned the S&P 500 to where it stood seven months earlier before last Fall’s dramatic slide.  Whether via risk-managed indexing using Smart Index and Legacy Navigator or non-correlated VIX exposure with Alpha Seeker, our process has produced a significantly smoother ride during this consolidation, leaving our portfolios well-positioned to capture the market’s next trend.   

As to which direction that may be, there seem to be conflicting messages at present.  In particular, the strong bounce in stocks is at odds with Treasury yields that appear to be pricing in lackluster economic prospects.  Taken together with declining earnings estimates, this means that the rally this year is almost entirely a result of an expansion in the price to earnings ratio rather than any improvement in fundamentals.  In other words, the rally this year has set the bar high that either earnings will improve substantially or that rates will remain low enough to justify an elevated multiple.  Even if these expectations are eventually met, It’s difficult to imagine that squaring such a wide divergence will go smoothly.  After one of the best quarters in S&P 500 history, it may be time for investors to re-evaluate their risk management plan. 

March 2019 Commentary

VIX CURVE STILL HESITANT AS STOCKS APPROACH SEPTEMBER HIGHS

Mirroring the S&P 500, US Equity Smart Index capped off a strong quarter in March, while a hesitant VIX curve continued to be a drag on Alpha Seeker.  As we have often repeated, our basic strategy is to use the VIX futures curve as a portfolio exposure guide.   Having studied it since its inception 15 years ago, we believe the VIX curve to be the single best indicator of market risk aversion available.  From beating the market in the record low volatility in 2017 to profiting in the worst December since the Great Depression, we’ve successfully used this process to produce non-correlated return through many different market environments over the past seven and a half years.

Like any investment process, using the VIX curve in this way is not perfectly consistent over every time frame.  As we’ve seen more than once since 2011, the VIX futures curve (and hence, our portfolios) can be slow to normalize during sharp “V” bounces in equities like we’ve seen this quarter.  Of course, the VIX curve may simply be reflecting the fact that healthy markets typically don’t plummet and rally nearly 20% in the space of 6 months while the economic backdrop deteriorates.  Abandoning our process to chase an unhealthy market has never been in our playbook, and we don’t intend to start now.   In time, we expect this to pay dividends just as it has in similar circumstances over the past seven and a half years.  

ALPHA SEEKER AND THE VOLATILITY CYCLE

 Another common theme in our work is describing the behavior of volatility as a closed “loop” which constantly repeats.  This makes the VIX unlike most other financial prices that can move freely between zero and infinity, entirely unanchored to any particular level.  

Past performance is not indicative of future results

Since its underlying market (the VIX) behaves fundamentally different than other exposures in a portfolio, an investment in Alpha Seeker should also be evaluated differently.  As an example, going against common sense from experience with other markets, Alpha Seeker forward returns have historically been 3x higher than normal after periods of negative trailing returns (see chart at right).  This is the cyclicality of volatility at work in a very practical sense.   

For a specific example, this quarter has parallels to the first four months of 2014 which saw a sharp “V” in the S&P 500 and similar Alpha Seeker results, both absolute and relative the S&P.  Investors who stuck with the process during that period then went on to enjoy the best winning streak in the strategy’s history to that point, outpacing the S&P while gaining an average of 2% in 12 of the next 15 months through July 2015.  A few months later, the S&P give back nearly all of the year’s gains while Alpha Seeker finished the year +15.3% and just 1.7% off its all-time high.  History will never repeat exactly, but this is precisely the type of return profile that makes for durable portfolios over the long run.  

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.