Is there a better alternative?
Mechanically, high-yield bonds have the same features as other types of bonds. They have a scheduled maintenance payment, a principal repayment at a specified maturity date, and in some but not all cases, maintain priority over other obligations in the capital structure. While the maintenance payment (or coupon) is typically fixed, the value of the bond is determined by the market’s assessment of the probability of repayment.
The Fed’s plan to tighten monetary policy and tighter regulation discouraging broker-dealers from taking risk, has led to less liquidity in the U.S. stock market and exacerbated daily moves.
WELL, THAT FIXES THE JUNE PROBLEM.
The S&P closed the month of May at 4132.15 and the month of July at 4130.29, with plenty to see in between, and with the VIX hardly at zero! It’s been a wild ride. In the short-term, I believe we have reached a top in commodity prices and inflation. The 10-year Treasury has found a “happy place” between 2.75% and 3.25%, and as discussed last month, earnings have not been as bad as many anticipated. The last few months have been a trader’s market, and not an investor’s market – and certainly not for the faint of heart. I believe we will drift around here with an upward bias until we have better visibility into the fourth quarter. I also believe that the fourth quarter will be one direction, up or down. Funny thing, at this point, I am leaning more bullish and could easily be convinced of an S&P at 4600 at year end, largely due to the new mixture of growth and value in the S&P today. I am still negative on growth tech and poor cash flow companies >> that check has not been cashed.
Currently, the VIX remains above 20, which is understandable and reaffirms that there is sufficient uncertainty to once again say that we are in a trader’s market rather than an investor’s market. The MOVE index, fixed income’s version of the VIX, fell from 150 to 120 in July. This is a significant, as the market is telling us that it is comfortable with the current path of the Fed and sees more certainty in the rates market going forward. The most telling metric continues to be the CSFB Fear index, which measures the market for skew. It started the month of July at 16.65 and ended the month of July at 16.79. This means that investors are not buying downside protection. In my opinion, this is resulting from a combination of two things: Investors remain underweight in their equity exposure but are now buying upside calls to synthetically increase market exposure. My experience has shown that while bullish, this is a very low conviction trade. Nobody is convinced that this rally will continue!
No Place to Hide
Diversified portfolios had another horrible month, the S&P was down 8.25%, the Barclays [Bloomberg] Agg was down 1.73% and GSCI was down 7.64%. The one major asset class that was positive on the month was the U.S. dollar. The DXY was up 2.88% on the month and, on the year, the DXY is up 9.42% with the Dollar/Euro moving towards par. I think this is a meaningful development as folks seek to resurrect the 1970s-style stagflation conversation. In my view, there are two major differences between today and the 1970s. First, in the ‘70s, we had recently moved off the gold standard. Eliminating the peg drove the dollar much lower against other world currencies. Second, at that time, the U.S. was a net importer of commodities (especially oil) and was dealing with the newfound might of OPEC and thus weakness in the dollar had a major impact on inflation. Certain commodity prices are spiking again but this time, we are a net exporter, and the case can be made that the that the US dollar is benefiting from higher oil prices. Another important factor is that earnings are transitioning from New York and San Francisco to large oil-producing states like Texas and North Dakota. The pundits seem anxious to call a recession when, in fact for the time being, we are dealing with a war launched by a Petrostate and adjusting to a world of higher interest rates and more expensive capital. As for a recession, that remains to be seen.
Volatility has not been moving higher as the markets sell off. The CSFB index was trading below 16 just prior to month end, which means that investors are selling puts. Skew, the difference in implied volatility between out-of-money calls and out-of-the-money puts, as reflected in the CSFB index, has only been lower when we hit rock bottom in 2008 and 2020. The challenge with this “rock bottom” thesis is that the VIX was close to 80 during those times, not 30! Another meaningful observation is that the correlation between equity asset classes has been very low, with value and growth moving in different directions, Energy and Tech are the obvious example. This has been slightly different with Energy stocks selling-off with oil and credit is finally starting to show signs of weakness. If we continue to see follow through in these areas, we expect volatility to push higher. Said another way, we expect credit to take the lead of the near-term direction of the market. Finally, I am genuinely concerned about the market pundits’ commitment to recession. While there are some unusual behaviors in the market, in my view, the bad news is largely reflected in the equity market pricing, and I am genuinely constructive if credit stands its ground. However, if credit weakens, I see the VIX escalating, and equity market exposed to further downside. The fourth quarter is going to be very interesting!
Protect your gains and stay in the game
Buying outright puts to hedge equity downside can be costly and a constant drain on portfolio returns.
The Put-Spread Collar is the popular form of portfolio protection.
Passaic’s Hedged Equity strategy is a low-risk equity strategy that seeks to provide capital appreciation through equity market participation while limiting the downside.
Passaic’s approach to implementing a put-spread collar is driven by an informed understanding of option market dynamics which includes a proprietary view of implied volatility, term structure, and skew dynamics.
In this piece, we will briefly explain how various defensive options strategies and passive option indices work and why Passaic Partners’ tactical dynamic approach produces better risk-adjusted returns with transparency and liquidity.
May, a Month to Remember
May was a month to remember. The 20th marked the low in the S&P 500 futures at 3807, down almost 8%. The futures then rallied all the way back to finish the month unchanged. Nasdaq’s trough was significantly worse with a myriad of high flying Covid tech names getting destroyed. The recovery in the Nasdaq fell a little short of getting the index back to unchanged. Fixed income, which has seen incredibly high volatility this entire year, settled down with the Fed seemingly finding a ‘happy place’ with 10-year Treasury rates floating between 2.75% to 3.25%. Given the choppy equity markets, I suspect that we will see some very differentiated returns among managers this month.
What does this mean? If we hold here, shy of 4% in the 10-year, the market will maintain a downward range. 3800 to 4400 is a reasonable expected range with 4275 as single point of reference. If inflation continues higher, pushing the 10-year to 4%, all bets are off until we hit 3400, the pre-Covid high. The one thing that is making the ole market maker nervous is liquidity. In their last meeting notes, the Fed expressed concerns about liquidity in Treasuries. As the saying goes, if the Treasury market catches a cold, the equity market could get pneumonia. 50- to 100-handle days in the S&P are not healthy for markets or investors. Electronic markets and regulation have significantly reduced the number of capital providers and market-makers. Market-makers will not provide the liquidity advertised during periods of high market volatility, particularly outside of the top fifty single-name stocks and when investors need it most. Should the summer prove to be less volatile, it may be the right time to think about improving the liquidity of your portfolio. Is there sufficient liquidity to add risk? In this type of market, Liquidity should trade at premium and Illiquidity should trade at a discount. But that is just one person’s opinion.
And The Hits Just Keep on Comin'
In April, the S&P 500 Total Return index was down 8.72% and the AGG bond index was down 3.95%. Derivatively, a 60/40 portfolio is now down 11.61% on the year. While not news, it is the worst four months of performance for a 60/40 portfolio in decades. As we have forecast, we are now seeing bonds and equities with strong positive correlation. It is also safe to say that the bull market in bonds, which has existed since 1982, is now over. This is not going to change anytime soon as the Fed and the marketplace deal with negative real rates. This extreme circumstance is also prevalent in developed countries in Europe and Japan. I find one of the most interesting barometers has been the Yen. Dollar/Yen was up 6.57% in April, following a move of up 5.83% in March which is a massive move in a developed currency. For a country that imports all its commodities in dollars, that is going to create huge inflationary pressure. Point being, as bad as inflation is in the US, it is significantly worse in Europe (Ukraine war) and now Japan. The days of low inflation and interest rates are over and now we’ll see if central banks willing and capable to deal with it. More importantly, are investors’ portfolios ready for this significant change? Is the move in 60/40 and the high correlation of equities to bonds just the beginning of things to come?
We typically focus on what is happening with equity volatility and, to a lesser extent, other asset classes. 2022 is proving to be a year where focusing across asset classes and regions is becoming more relevant. For now, let’s look at interest rate volatility in the U.S. The “MOVE” is a volatility index created by B of A and ICE that tracks 1-month treasury volatility over a 2-, 5-, 10-, and 30-year treasury options. Above, we discussed how bonds are now in a bear market. The MOVE index confirms, like with equities, that as bond prices have gone down, the volatility of bonds has gone up substantially. The MOVE index was up 10.43% in Jan, up 17.92% in Feb, up 6.45% in March, and up 20.13% in April. While we are seeing uncertainty in equities with a higher sustained VIX, the increase in Treasury volatility is showing even more uncertainty in the rate market. With the 10-year hovering around 3%, market uncertainty, as seen through option volatility, has increased substantially. Our view, as stated last month, if we can hold 3%, the equity market will likely continue to trade in a downward trending range. If it looks like the 10-year is moving more towards 4%, the equity markets could get very ugly.
After Three Decades
March was one of the more interesting months I have experienced in my three-decade career. The war in the Ukraine has created major supply issues in commodity markets, outside of just oil. While most investors were focused on oil, nickel was the real surprise. The London Metal Exchange shut down nickel futures trading due to a short squeeze caused by one large producer. This situation undoubtedly warrants more attention than a simple commentary. My view is that market oversight of the EV related commodities will have to be more stringent, particularly as their impact on global economies will eventually become as important as oil.
Market volatility remains high. Market participants do not want to be short volatility, with the war in Ukraine, despite the Fed’s ambition. The Fed has now formally introduced the “Fed Call,” as I described in my last piece. The Fed Call and the well marketed “Fed Put” are going to keep the market in a range. The Fed will continue to raise rates to lower inflation; they will also attempt to manage volatility to help to calm investors’ nerves. Unless the Fed loses control of this narrative and rates exceeds 3%, the market will remain in a range. I expect this range to be slightly downward trending, unless a more significant rate hike is required. We are not naive to the fact that there are many factors influencing this story, but the Fed, currently, is the most important factor when it comes to the VIX.
February 2022 - Monthly Update
It is difficult to talk about volatility markets with what is going on in the world today. My hope is the war comes to a peaceful solution quickly and we can look back at all of this and think it was just a bad dream. With that hope, it appears that the market dynamics have become more complicated. In addition to the war, we can now say that we are in a much higher inflation regime and that rates really have only one way to go, which is up. That doesn’t leave the Fed much of a put anymore. We can also say the peace dividend of the 1990s is now gone. This likely means the PE ratio of markets will have to go lower. We can see in gross and net numbers of hedge funds that managers are not just reducing net exposure, but also gross. This shows itself in the options market through the skew numbers or the CSFB. As I write this, the CSFB is in the mid-20s. In other words, as people take off risk, they are reducing hedges. You don’t need a hedge if you have less exposure or are in cash. My thinking is we are in a bear market with some violent bear market rallies. With the VIX already high, I think the selloff will be more drawn out than we are accustomed to in a typical bear market. And one school of thought is that we need a good case of fraud for any bear market to end, so I am waiting for that! 2022 is likely to prove to be a tough year.