There’s a little bit of Bonds in Everything we do!
It takes a good old-fashioned run on the bank to remind us how correlated all investments have been to bonds. Last year, bonds almost broke the UK pension system. This year, bonds have led equities up and back down, led banks to insolvency, and led to pressure on private assets, whose profits are largely dependent on ‘cheap money’. Pundits and politicians alike can blame the Fed, but bonds are simply a tool, and the real blame lies in poor risk management. The Fed has made their intentions eminently clear; it is the decision of risk managers/supervisors to act or, in the case of SVB, ignore those risks.
In February, equity volatility, as measured by the VIX, held within the range of 17.5 to 22.5. With the onset of SVB et al, the VIX hit an intra-day high on Monday, March 13 of 30 and settled at 26. The swift action or intention of the trifecta of government agencies (Federal Reserve, FDIC, and Treasury) has calmed the nerves of investors. As things settle down, we anticipate that the VIX will return to the aforementioned range and the Fed will get back to the business of quelling inflation.
Nobody Beats The WIZ!
What a January. 2022 was forgotten, with the S&P up over 6%, the Nasdaq 100 up over 10%, EM equities up over 9%, and Global equities up over 7%. As the Wizard of Oz said, “pay no attention to that man behind the curtain!” Morgan Stanley publishes a momentum index based on long/short equity momentum trades. That index was up more than 36% in 2022. In January, it was down over 16% because it entered the year, long oil and value stocks, short growth tech stocks. Momentum got absolutely hammered in January as most everything reversed course. What is this telling us? Is this the start of a new bull market? Is this a short covering bear market rally? Our view remains the same that the S&P 500 is in a range from 4250 to 3750. In order for the market to breakout of this range, we believe that the data needs to improve. We would like to see stronger earnings and greater certainty in short-term credit. Until that time, momentum, trading, and algorithmic strategies will continue to have a much bigger impact on the market than fundamentals.
The VIX is hovering around 20, which we think is a fairly valued in the current market. In fact, we believe a reasonable trading range for the VIX would be 17.5 to 22.5, barring any unforeseen circumstances. The adjustment to a lower range is driven by a drop in fixed income volatility as the FED reaches its terminal rate. Importantly, investors are starting to believe in the range trade. Moreover, in our opinion, the market is being over-traded. Eventually, as traders buy enough tops and sell enough bottoms, they run out of leash. This circumstance will lead to a VIX closer to 15 and the aftermath of the over-trading environment we experienced in 2010 and 2011 will happen again. A lower volatility regime would make trading difficult in 2023. Conversely, investment strategies that do well in a range and manage risk, may perform the best.
1000 basis points!
We don’t often boast about our results, but 2022 was unique in many ways. Our Hedged Equity strategies (U.S. and Global) outperformed their respective benchmarks (S&P 500 and MSCI ACWI) by more than 1000 basis points, blended portfolios (60/40) by more than 800 basis points, the CBOE put-buying strategy (PPPU) by more than 1200 basis points, and the CBOE tail-hedging index (PPUTM) by almost 1000 basis points. Our Beta One Equity strategy outperformed the S&P 500 by more than 300 basis points. While we pride ourselves on our upside capture, how our strategies behave in a bear market can be an important factor that differentiates us from our competitors. We believe our ability to adapt to, tactically adjust, and manage risk through changing market conditions has enabled us to outperform our competitors. Please see our monthly fact sheets for long-term performance information and the associated disclosures.
December was a difficult month for U.S. equities in large part due to broad risk reduction and tax-loss harvesting by many market participants. U.S. technology stocks took the brunt of the hit, with the Nasdaq down more than 9%. Tesla weighed down the S&P with a 36% loss. The 10-year Treasury Bond moved from 3.61% to 3.87%, Oil was flat, Silver was up over 10%, the U.S. Dollar fell over 2% as the ECB became more hawkish while the Fed hinted at backing-off. The one market that continued to be positive was China. Looking back on the year, investors and managers alike are relieved that 2022 is over; equity and bond managers are happy to start fresh and most macro/trading shops, having had a very strong Q1 & Q2, are happy to have not given it all back. There is still some denial on private valuations but that should work itself out by Q2.
Owning outright puts was not an effective way to hedge this year. The VIX averaged ~25, which is well above the historical average of ~15. While markets have been choppy and produced some big moves, it was not enough to pay for those puts. Part of the reason that owning puts was not profitable this past year is that the cost of implementing out right puts has gone up as there are fewer sellers in this market as result of the downdraft in 2020 where tail hedgers won and those issuing the insurance lost. This has naturally led to fewer sellers of insurance, and thus, higher prices to those who want to buy it. We believe that a tactical hedging strategy is more effective than a one-size-fits-all swing for the fences approach. We would rather be roughly right than completely wrong.
Keep Calm and Stay Alert
It was a heck of a month to be investing cautiously in global equities. MSCI ACWI was up 7.60%, led by emerging markets which were up 14.64%, EFA (developed markets outside U.S. and Canada) were up 13.17% and the SPTR was up 5.59%. A large part of this rally was led by a selloff in the U.S. Dollar as the DXY was down 5% in the month of November, which is a big move in the currency markets. We finally saw bonds move higher with the 10-year Treasury future up 2.37% on the month. We believe that markets started pricing-in the end of the Fed tightening cycle. Whether you believe that we will reach an end to higher rates early next year or not, the market is telling you that that is the current course. We continue to believe that we are range bound until we see concrete evidence that earnings can continue to rise. Keep in mind, bonds are rising because the fixed income market is pricing an economic slowdown in the second half of next year. This is not bullish for equities. We expect a rangebound year for SPX, somewhere between 3750 and 4250. And by the way, we are still bullish Gold and Silver.
The VIX continues to be a depressed asset, falling from 25.88 to 20.58 by the end of November. While this is primarily driven by the equity rally and a less hawkish Fed, the other variable driving the VIX is lower realized volatility. Except for the Fed announcements and inflation news, markets have been in a holding pattern. In our October 2022 commentary, we wrote about the increase in trading of one- and two-day options. It has paid to be short volatility and to use one- or two-day options to “hedge” the Fed announcements and inflation news - - similar to how single name options trade on earnings days or a biotech trades on drug trial results. This trade has worked very well for the better part of the year, but we believe that once the Fed finds its “happy place,” this will change. We continue to believe that equities are range bound until market participants get a better feel on earnings within a higher rate environment. We also see the 10-year Treasury moving into a range between 3.25% and 4.50% and we expect the dollar will be more stable as the ECB is now more hawkish than the Fed. Our conclusion: trade the range next year, sell volatility, and keep a close eye on earnings.
The Fed will succeed.
Dispersion abounds. While U.S. and European equity markets produced a strong recovery in October, Asian and the broader emerging markets lagged substantially. Similarly in the U.S., the Dow Jones Industrial Average was up just under 14% while the Nasdaq 100 was up less than 4%. Earnings in the old economy stocks, led by JP Morgan and Exxon Mobil, substantially outperformed the likes of Microsoft and Amazon. S&P 500 P/E has firmly established a low at ~15 with the “E” is moving markets higher. All of this good news for the equity markets occurred as the Fed reaffirmed its commitment to stomp out inflation and as the US Aggregate Bond index sunk lower to finish the month down 1.3%.
A lower CPI number and a meaningful number of lower real estate transactions showed that the Fed’s efforts are starting to have their desired impact. One metric that remains strong is employment. This will allow the Fed to continue to move terminal rates above 5%. We certainly didn’t expect equity markets to hold up this well given the speed and ferocity of the rate rise. Should a soft-landing not happen, we can all take comfort in the fact that rates above 5% will afford the Fed sufficient ammunition to fight a recession. So, we expect the Fed to speak softly while they continue to wield their big stick.
Another interesting phenomenon is the dollar weakness, largely driven by the Fed hinting at a terminal rate. The DXY was down 0.53% in October. We believe that dollar weakness and reevaluation of crypto will lead to a rally in the most hated asset in recent history, gold. Drop the mic!
Working toward stability.
VIX continues to grind lower. Implied volatility is pointing to a more stable market environment for equities. Moreover, as the Fed’s hiking begins to subside, stabilizing the rates market, investors who have been underweight equities will likely become buyers who aid the VIX’s continuing decline.
Downside is limited because the Fed’s ability (dry powder) and willingness to change direction. If the Fed believes that it has gone too far too fast, we believe it will make the appropriate adjustments. Reenter the Fed Put. Before that happens, we expect to see bad actors and unprofitable growth businesses exposed. We do not anticipate a V- or U-shaped equity market recovery, but rather a sideways market with an upward trend over the next 12-24 months. Aligning with above point, we anticipate that the VIX will migrate below 15 in 2023.
Bad behavior in the options market. Currently, 40% of the SPX volume is in 1- and 2-day options. As longtime option practitioners, we view this as gambling, not investing. We do not believe that this is a sustainable investment strategy. As these temporary entrants go away, again, the VIX will continue lower.
Tiptoeing backwards out the door. Having failed at a ground war, a draft, a reengagement, and drone attacks, Russia is shifting its attention to its only remaining leverage over the U.S., Brittany Griner. In thinking about possible tail events that could jolt the VIX, we do not expect Russia to engage with nuclear weapons, nor do we anticipate an invasion of Taiwan by China. If either of these happen, the shock to the VIX will be the least of our worries.
Stickier than any of us thought.
Inflation is stickier than any of us thought, and the Fed is determined to wipe it away. Traditional inflation-linked assets are not serving as a proper hedge. Last month, gold was down 3.14%, oil was down 11.23%, TIPs (ETF) were down 7.91%, and REITs (IYR ETF) were down 13.62%. U.S. equities (S&P 500) had the worse month of the year, down 9.34%. Bonds continued to provide no protection with 10-year note futures down 4.14% and 30-year bond futures down 6.95%. As noted in our April 2022 Commentary, and again in our May 2022 Commentary, a 4% 10-year treasury yield would make for a very interesting environment . . . and that is where we are. Since the GFC we have kept rates low, afraid of repeating the mistakes of the 1930s. Today, post the pandemic stimulus, we are raising rates to prevent the mistakes of the 1970s. We continue to believe that strategies that benefited from low to falling rates are going to have issues: growth tech in public equity and risk parity funds in fixed income. What is the next shoe drop? It is difficult to say. Who expected LDI issues in the UK pension fund market? The key question is, what is the driver of outperformance? If there is leverage, where does it come from and does it make sense to continue to invest that way? Will investors accomplish their investment goals with higher rates? One last thing, if Yellen is talking about liquidity of treasuries, please think about liquidity across all asset classes and investments. We believe that investors should trade when you can, not when you have to!
We are not big believers in equity tail hedges. If you are one of the select few that owned tail hedges on bonds and currencies in September, kudos! We are now seeing implied volatility in currencies and bonds in the top 10% of historic levels. The result of unwinding fifteen years of bullish Central Bank policy. Now, where do we stand? We are much more constructive on U.S. equities with the SPX at 3600, P/E of 15, 10-year yield at 4%, and the VIX at 32. Looking back at the 1994 through 1995 Fed actions, yields had dropped from 8% to 5%. In 1994 the Fed raised rates which brought the 10-year back to 8%. In 1995, the FED lowered rates to 6%. Why is this important? At that time, the SPX P/E was 15, granted we had just come out of a nasty recession prior to 1994 and things were looking up. What we find most interesting, is that during this time the VIX was 12-13 and skew was incredibly flat. Consider this in comparison to the current environment, VIX at 32! Said a different way, we are still committed to the theory that equities will remain in a range, at least for the short term. The economy is still cooking and while I write this, we are seeing good earnings in old economy stocks, not semi-conductors, but staples. If the E in P/E doesn’t come down, like many are expecting, equities will likely see significant upside because so many large pools are very underweight in public equites. I think that there is a good chance that this year may be followed by a 1995 style rally. In fact, it may have already started!
This year continues to be demanding, with extreme moves across all markets. At its highest point in August, the SPX was up 4.5%. It sold off almost 9% from there, to finish the month down 4.2%. This followed a 9% up move in July and 8.4% down move in June. What is telling is that the SPX hasn’t really gone anywhere since the major sell-off in April. While the SPX has been volatile and it has been a challenge to manage risk, the SPX hasn’t really given up much in the way of level since the middle of the second quarter.
Following a big move in March and April, the 10-year note is hovering around 3%. We have seen yields as high as 3.5% in June and as low as 2.5% in August. Our view is that 2.75% - 3.25% is a reasonable range for the foreseeable future.
Commodities continue to struggle as gasoline futures dropped 25% in the month of August. Comparisons have been made to 2008, where a recession led to a commodity sell off. We don’t think that will be the case this time. In fact, we believe that it is simply the end of the summer travel season and don’t expect demand to pick up anytime soon, as folks are committed to working from home at least part time and limiting business travel as part of our new realty.
Lastly and most importantly, the dollar continues to go higher, up 2.64% against the DXY basket on the month. We continue to believe that the dollar strength comes from the U.S. exporting energy. We are sticking with view that the fourth quarter will continue to be a roller coaster across equity and fixed income markets, though we may end up in the exact same place that we start.
Everyone is asking, why doesn’t the VIX go higher?
First, this is a market about positioning and not fundamentals. In other words, we go higher when investors must buy, and we go lower when investors must sell. Investor’s positioning, both gross and net, continues to be light. We experienced this in 2009. If investors are light on positioning, they don’t need to buy insurance, since they have very little to insure.
Second, the realized correlation within the SPX is very low, i.e., energy vs tech. The way this works: as the price of oil increases, oil stocks rise, bonds fall, and the dollar strengthens. This has been broadly negative for tech stocks. Conversely, as the price of oil decreases, oil stock falls, bonds rise, and the dollar weakens. This has been broadly positive for tech stocks.
Third, realized volatility is not that high. The 100-day is 26.36, the 50-day is 19.60, the 30-day is 19.64, and the 10-day is 17.50.
Finally, we haven’t had any issues in the credit markets, to date. In our opinion, it is difficult to justify a VIX above 26, with relatively stable credit markets.
So, why all the equity volatility in the first place? In a word, trading. This is a trading market. The best performing funds this year are CTA, Macro, and multi-strategy trading funds. These strategies have attracted new money, which means more trading. Based on our experience as traders, and the current VIX, our belief is we are moving into a wide range. Yes, a range. The equity premium will not see the quick reset most market participants are expecting, SPX 3000, but more a range for longer than many anticipate. This will take equity risk premium down. The VIX will continue to fall as trading groups get chopped up trying to trade trends, buy highs and sell lows. One of the many things that we observed on the trading desk when our team was on the sell side was investment strategies that did the most future/ETFs trading volume in a one-year period struggled and even closed its doors the next year, without the sustained market volatility. That is where we are now.
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!
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.