Derivative market stress abated in first 5 months of 2019, driving gains for short volatility investors

Back in 2018, US market equity market volatility caused our derivative market stress indicator to signal bearish positioning for 61% of the year. For a quick reminder of what was behind 2018’s volatility, take a look at this post. This means that our dynamic derivatives clients’ assets spent most of 2018 in cash or 10-year US treasuries, waiting patiently and safely for better opportunities to emerge.

The first 5 months of 2019 has shaped up to be a time of better opportunities. As the recession scare of Q4 2018 wore off, subdued volatility in equity and derivative markets has driven our derivative market stress indicator to signal bullish positioning for 66% of this year, through the month of May. The difference in short volatility conditions, and in the positioning of our indicator, is evident in the chart below.

*Past performance is not necessarily indicative of future results

*Past performance is not necessarily indicative of future results

Early May saw a surprising return of volatility - surprising because after months of headlines signaling positive developments in international trade negotiations with China, over the May 4th-5th weekend the US announced that the tariffs against Chinese imports would be levied after all, and that negotiations were headed nowhere. Our derivatives market stress indicator quickly turned bearish, and as a result our dynamic derivatives clients spent the rest of May in cash or US treasuries (depending on the strategy).

Government stimulus drove almost all of past 10 years’ S&P 500 gains

You’ve probably seen a chart like this one, showing the striking relationship of the S&P 500’s gains in the past decade to Federal Reserve stimulus phases 1, 2, and 3, known as ‘quantitative easing.’ But perhaps you’ve wondered if that relationship is just a coincidence.

Well, the fourth quarter of 2018 made clear it’s no coincidence.

S&P 500 and Fed Bal Sheet over time.png

We’ve marked periods on the above chart as easing, pause, and tightening, corresponding to whether the Federal Reserve was putting money into the economy, standing pat, or taking money out. Note we’ve also marked the ‘Tax Stimulus’ period, in which government economic stimulus was being applied, but not by the Fed.

Then we graphed these periods by average S&P 500 weekly return in each period vs. the amount of money each week the Fed injected into (or took out of) the economy in that same period, and ran a regression.

S&P 500 vs Fed Stimulus.png

What’s clear is that Federal Reserve stimulus drove most of the S&P 500’s gains over the past 10 years, and tax cut stimulus drove the rest. With an R-squared of 93%, data scientists call this sort of relationship a slam dunk. Rarely is such correlation between cause and effect found in the real world.

Now that the Federal Reserve is unwinding its balance sheet and is reluctant to lower interest rates, what does this mean? Sustainable gains in equities are becoming more elusive, and protecting against volatility will be critical.

Derivative market stress indicator protects our dynamic derivatives clients from much of 4th quarter 2018 volatility

The short volatility asset class generally experiences its best returns when the outlook for US stocks is improving or static, as occurred in 2017 with a rebound in GDP growth and the passage of the Trump federal tax break (click here to read more about that in a previous post).  

It generally experiences its worst returns when the outlook for US stocks is deteriorating, as occurred in Q1 2018 with trade war talk coinciding with the arrival of a new hawkish Federal Reserve chairman, worrying investors that inflation and tight money might all be coming quickly (click here to read more about that in a previous post).

It happened again more severely in the 4th quarter of 2018. While headlines were focusing on investor fears of recession, we think the real driver of stock market volatility was the unwinding of the Federal Reserve's balance sheet (click here to see the analysis we later shared on this point).

The chart below shows how our derivative market stress indicator helped our dynamic derivatives portfolios avoid most of the 4th quarter’s volatility. Our Titan strategy avoided more than 2/3 of the short volatility index’s decline.

*Past performance is not necessarily indicative of future results

*Past performance is not necessarily indicative of future results

Arrival of Hawkish Central Bank leadership in first half of 2018 is increasing volatility and competing with earnings growth to drive stocks’ direction

Recall that in early February of 2018, there was a brief burst of intense equity market drama.  The arrival of a new, potentially more hawkish US Central Bank chairman coincided to the day with an unexpectedly strong US employment report. These circumstances implied that a more aggressive Central Bank interest rate path was in the offing, causing a rapid but limited equity market selloff, and an accompanying increase in daily volatility that lingered for many weeks. 

By contrast, the second quarter was relatively quiet for our strategy.  In April, due to ongoing volatility from the first quarter, our indicator kept our clients defensively positioned for the first two weeks of the month, incurring some small losses.  But in May and June our indicator signaled a return to offensive exposure to equities, driving gains in both months.  In the final week of June, a Trump administration announcement of trade tariffs on $200B of imported Chinese goods led to a brief selloff in equities that reduced our gains in the month, but it wasn’t enough to switch our indicator back to defensive.


When geopolitical news or Fed chairman turnover drives short-term stock volatility despite robust company earnings growth, as was the case in the first half of 2018, it generally is due to professional investors’ macroeconomic rules for predicting company valuations.  For example, more rapid interest rate increases by a hawkish Federal Reserve can imply that money supply across the economy could decrease, reducing consumer spending and company borrowing.  New trade tariffs on Chinese goods can imply that a trade war with China could reduce U.S. company exports, and could increase costs for items manufactured in the U.S. from Chinese components.

This sort of news-driven heuristic is currently competing with the upward stock price pressure of earnings growth. According to Thomson Reuters, S&P 500 earnings grew in the second quarter of 2018 by a remarkable 22.6% from the same quarter a year ago. Another heuristic competing with strong earnings growth is the potential impact of an inverted yield curve:

Schwab inverted yield curve.png

Source: Charles Schwab & Co.

The plot shown here is of the interest rate difference between 10-year and 2-year US government bonds.  As the Federal Reserve raises interest rates during a typical economic expansion, it eventually pushes 2-year interest rates higher than the interest rate on 10-year bonds, causing a negative difference between the two rates, resulting in an ‘inverted’ yield curve.

The chart demonstrates that such a condition has preceded every U.S. recession since the 1970s, albeit with significantly varying time lag in each case.  For instance, the 10-year to 2-year yield spread fell below 50 bps in early 1995, a full six years before the 2001 onset of a recession and bear market in U.S. equities.  An investor using the yield curve’s breach of this threshold as a signal to get defensive would have missed out on the remarkable returns of the 1995-2000 period and would have waited nearly a decade for the decision to pay off.

While the U.S. economy’s expansion continues to mature and approach an eventual correction, our analyses have shown us that when it comes to identifying periods to be offensively or defensively positioned to U.S. equities, our indicator system is better positioned to do so than any macro-economic heuristics such as those mentioned above.  So as various news items continue to drive brief periods of volatility while S&P 500 earnings growth powers on, we’ll continue to use our indicator system to position your assets to benefit from potential equity gains and to protect against potential losses.

Derivative market stress indicator protects our dynamic derivatives clients from most of February 2018 volatility

Note: this client note has been edited since it was originally sent to our clients in 2018, in order to clarify language related to our dynamic derivatives portfolios

Our derivative market stress indicator is designed to bullishly position our dynamic derivatives portfolios only when conditions are consistent with the likelihood of positive returns and a reduced probability of steep losses.  In general it has us bullish (that is, shorting volatility) when equity market volatility is relatively high but declining, and bearish when equity markets are abnormally calm or becoming more volatile.

The first quarter of 2018 brought a sharp transition from a very low volatility equity market regime to one of above average volatility.  To us it was a transition from a regime in which it was difficult to profit in derivatives without taking undue risk, to one in which we expect shorting volatility to be profitable again with an acceptable risk profile. 

Our system is designed to avoid much of the steep potential short volatility losses during such a transition.  In the first quarter our Titan strategy avoided 84% of the losses incurred by the VIX Short Term Futures Inverse Index.  The index suffered its worst losses in the quarter on three separates instances in which the VIX index jumped by more than 25% in one day; our derivative market stress indicator had our client assets protected in cash for all three.

Our previous Titan client note was sent out on February 1st of this year.  Coincidentally, the Titan system had just moved our clients’ assets to cash on January 29th.  The note reflected on the eerie calm prevailing in equity markets. The very next day after we sent that note, Jerome Powell arrived as the new Federal Reserve chairman, and the Bureau of Labor Statistics released an unexpectedly strong employment & wage report. 

Those two relatively innocuous items combined to make it evident the Federal Reserve would likely raise interest rates 4 times in 2018, setting in motion a rapid equity market selloff and accompanying volatility spike.  On Monday February 5th the S&P 500 index declined 4% from its Friday close, its largest close-to-close decline in over 6 years.  The VIX index (recall that the VIX is essentially a normalized price for equity downside risk insurance) increased by 116%, its largest one-day percentage change ever.   

The transition from low volatility to high volatility, which commenced January 26th and was complete by February 8th after delivering a cumulative 10.1% S&P decline, was remarkable partly because it came so quickly following the 7.4% S&P sprint higher in January. Over the last ninety years, equity price momentum has never exhibited such dramatic short-term deterioration. One World War, one Great Depression, thirteen other official recessions and various financial panics all did not generate the reversal in equity price action observed in the first 6 weeks of 2018.

Realized volatility remained elevated for the remainder of the quarter, with the February-March period registering annualized realized volatility of approximately 24%, double the non-recessionary volatility since 1990, and more in line with that observed in the recessions of 2001 and 2008-2009. A return to elevated levels of equity market volatility was to be expected, and is in fact necessary for our dynamic derivatives portfolios to have meaningful opportunity for profit in the future. So we welcome the first quarter’s reset to a higher, more typical level of volatility.

Dynamic derivatives strategy 2017 year in review

Note: this client note has been edited since it was originally sent to our clients in 2018, in order to clarify language related to our dynamic derivatives portfolios

2017 was the first full year in operation for our dynamic derivatives portfolios, and we are pleased to say that their actual performance was highly similar to the performance for which they were designed:

  • In 2017 they had bullish positioning (meaning exposure to the short VIX futures ETF position) on 125 of 251 trading days, and were in bearish positioning the rest of the time.  This was in line with our hypothetical model, which shows bullish positioning 45% of the time and bearish the remaining 55%

  • Our derivatives market stress indicator caused execution of 24 individual trades.  18 of these generated positive return, for a 75% batting average, which is somewhat better than our hypothetical model’s 66% winning trade batting average

  • Our Titan strategy's net annual return of 48.3% in 2017 is in line with our expected average annual return of ~50%, based on hypothetical backtesting

Our Titan dynamic derivatives strategy is designed to offer our clients a way to aggressively speculate in an asset class that is meaningfully different from traditional equities, fixed income, and commodities.  The industry term for Titan’s asset class is ‘volatility,’ but to us at Huygens it is more instructive to think of it in terms of insurance.  Titan takes advantage of a persistent mis-pricing of U.S. equity market insurance instruments, driven by large institutional equity portfolio managers’ (think Capital Research, Fidelity, AllianceBernstein, Franklin Templeton, in addition to large hedge fund firms) need to hedge their downside risk.  Because of the large amount of equity exposure being hedged, it is a particularly difficult pricing anomaly to arbitrage away.

We expect that all of our clients are well aware of the benign equity investment conditions prevalent in 2017, so we won’t discuss them here.  Instead we will focus on just the volatility of U.S. equity returns, because this is what drives Titan’s return generation process.

Both implied and realized volatility set new record lows in the US, dating to the creation of the VIX index in 1990.A few brief spikes of implied volatility did occur - on three occasions the VIX index increased more than 30% in a single day, during all of which the Titan strategy was in cash - but overall 2017 was utterly bereft of equity market swings.Below we highlight a few of the specific ways in which 2017 was out of the ordinary.

Before 2017, it was rare to see the VIX index close below 11.0.  In 2017 this occurred more times than in the prior 26-year history of the VIX Index combined; see chart below.  2017 recorded the lowest ever VIX Index average for a month (October: 10.1), a quarter (3Q: 10.3), and a year (11.1).

20190609 Days VIX below 11.png

Of course the VIX Index measures the price of insurance, as derived from the prices of options that reference the S&P 500 Index.  This insurance was so cheap because 2017 was also an extraordinary year for actual realized volatility.

20-day realized volatility - the standard convention when comparing to the VIX index - averaged 6.7 in 2017, dramatically below its average since 1990 of 15.7.  Sharp market moves were both small and rare in 2017.  In a typical year, the S&P 500 index will suffer a single day decline of more than 1% 30 times and of more than 2% nine times.  In 2017 there were four single-day selloffs of more than 1% and no declines greater than 2%.  Indeed, the single worst 2-day decline in 2017 was 1.9%.  The below chart shows historical levels of both implied and realized volatility, back to 1990:

20190609 VIX vs Realized.png

It should be noted that all of Titan’s 2017 gains were earned in the first quarter.  The ultra-low volatility conditions described above really took hold in the second quarter of 2017 and continued through year end, making equity downside insurance extremely cheap.  Because of the steep negative response of the VIX to small market perturbations at such low VIX levels, we deem the risk of an ugly reversal and steep losses in such conditions to be too high.  As a result our system, after enjoying the conditions of the first quarter, sat out much of the remainder of the year. 

Based on past history, the U.S. equity market won’t remain in such a low volatility state permanently.  And when volatility returns, our Titan strategy will be ready to capitalize on it for our clients.

Huygens equity market stress indicator stays on offense as economic strength continues

The story of the third quarter is very similar to that of the second quarter.  It stands out as an almost uniquely calm period for US equity markets. Consider:

  • In the 27 years from VIX index inception in 1990 through the second quarter of 2017, the VIX Index closed below 10 on 16 days.  In the third quarter of 2017 alone, the VIX Index closed below 10 on 17 additional days.  The quarter represents less than 1% of trading days in the past 27 years, but more than half of all sub-10 VIX closes.

  • The overall VIX Index average for the quarter was 10.94, the lowest in history.

  • One week in late September saw the S&P 500 move less than 0.5% (intraday peak to intraday trough), the tightest such one-week range since the 1970s

Placid periods for U.S. equity markets generally correlate to positive returns. The chart below plots Russell 2000 quarterly returns against prevailing average VIX levels in the same quarter. The large green data point at the leftmost end of the distribution represents the third quarter of 2017.

VIX vs total return.png

The chart demonstrates that when equity market volatility and implied volatility are this low, returns tend to be quite positive and narrowly distributed around the positive expected outcome.  As the average VIX level increases, the expected return falls, and the range of possible returns increases dramatically.  Those of you that check our market stress indicator regularly or receive our signal email weekly may have been wondering why it has remained in the offensive state since November of 2016.  The above chart hopefully makes the answer clear: with implied volatility this low, it is best to stay the course with equities and maintain full exposure.

Low equity market volatility generally results from positive investor sentiment regarding economic conditions.  The third quarter’s abnormally low volatility coincides with, and likely results partially from, an almost equally rare confluence of good employment news (all charts sourced from 

  • Steady job creation has continued in 2017, with no sign of slowing



  • U-6 unemployment (which measures the unemployed plus those workers that are employed part-time for economic reasons) has returned to its pre-crisis level, indicating most workers displaced in the crisis have now found full-time employment



  • The ratio of job seekers to job openings is at its lowest level of the past 17 years



In such an employment environment, workers can be forgiven for feeling relatively safe in their jobs and looking forward to rising wages, as reflected in high Conference Board consumer confidence readings:



In summary, sustained strong improvements in employment have finally overcome the consumer caution that lingered for so long from the financial crisis.  These developments seem likely to enhance current positive economic conditions in the near future, and therefore contribute to the ongoing low volatility equity market.

Huygens equity market stress indicator continues to maintain bullish positioning in strong bull market conditions

There are many ways in which the second quarter of 2017 was unusual for U.S equity markets, especially with regards to market volatility. 

Recall that the VIX index reflects a normalized price being paid by investors for protection against downside movements in the S&P 500 index.  Lower readings of the VIX imply relatively low demand by investors for this protection.  VIX closing levels below 10.0 have been exceedingly rare:  over a 27 year period  (January 1, 1990 through April 30, 2017) there were only ten days on which VIX closed below 10.0, the most recent being in January of 2007, well before the Global Financial Crisis erupted. 

Then, in May and June of 2017, the VIX index closed below 10.0 on seven additional trading days and averaged 10.69, the lowest 2-month average level in its 27-year history.   Equity market behavior has for now justified such low demand for protection:  The S&P 500’s peak-to-trough range (one measure of realized volatility) in the month of June was the narrowest it has been since the 1960s.



One possible explanation for such investor confidence toward U.S. equities is that the S&P 500 appears to have genuinely emerged from its earnings recession of 2015 and 2016.  The above chart shows that operating profit per share, and management expectations for earnings per share, declined significantly in 2015 & 16.  That trend has now reversed, and if the current profit cycle follows the pattern of past cycles, there is the potential for several more quarters of S&P 500 profit growth ahead.

Source: National Federation of Independent Business (NFIB)

Source: National Federation of Independent Business (NFIB)

The National Federation of Independent Business, a trade organization for small U.S. businesses, publishes the above small business optimism diffusion index.  It combines quantitative measures, such as changes in small business inventories and job openings, with responses to survey questions such as expectations for future revenue growth.  The index remains near the historically high levels it reached immediately after the presidential election, signaling a sustained level of economic optimism not present in U.S. small businesses for over a decade.

Such optimism, low equity volatility, and low fear of volatility, might be taken as a signal of investor complacency and an early-warning sign of a market top. A risk-averse investor might seek to take profits in such conditions. Our analyses of the historical VIX index and equity market data going back to 1990 have shown us that the best approach to such low volatility regimes is to maintain exposure to equities. Our indicator system has done just that in 2017, driving steady positive returns for our strategies and for our clients.

Huygens equity market stress indicator maintains bullish positioning amid accelerating earnings growth, protecting against behavioral response to alarming headlines

The first quarter of 2017 saw a steady stream of unsettling domestic and international news.  An investor observing this would have likely expected much worse equity market volatility than was experienced, and might have been tempted to entirely avoid exposure to the equity market.  However equity market volatility was at very low levels - the S&P 500 Index went 55 straight trading days without a 1% or greater move in either direction, and the VIX index averaged 11.7 in the quarter, the lowest first-quarter average on record going back to 1990.   Protection against the behavioral tendency to react to news flow is one of the main benefits our system is designed to provide.   Our signal remained in the ‘offense’ state throughout the quarter.

Source: NFIB

Source: NFIB

Despite all the disquieting headlines, equities are currently being supported by many positive factors: S&P 500 earnings are strongly growing again after declining for several straight quarters; the Federal Reserve is raising interest rates at a measured pace, comforting investors that no surprise moves are in store while simultaneously encouraging portfolio rebalancing away from bonds and into equities.  Perhaps one of the strongest factors supporting equities is sentiment.  The above chart from the NFIB, a trade association for small businesses, shows the recent dramatic rise in small business optimism, likely responding to the current administration’s aggressive pursuit of a pro-growth agenda.

A nervous investor could be forgiven for feeling pessimism, however.  The U.S. manufacturing sector continues to stagnate, with production volume remaining essentially flat for the past five years at a level equal to that first reached in 2004, and well below the peak level reached in 2007.



Meanwhile global debt as a percent of GDP has continued its rise and now exceeds levels seen in the depths of the financial crisis.

Source: International Monetary Fund

Source: International Monetary Fund

Perhaps most concerning is a recent steep decline in the growth rate of U.S. bank lending.  The causes for it are unclear, but its coincidence with the Federal Reserve’s positioning on interest rates in late 2016 is uncanny.  If the decline continues it signals the exact sort of credit market tightening that has contributed to past recessions.

Source: Wall Street Journal

Source: Wall Street Journal

While certain economic indicators are promising and business is feeling optimistic about growth prospects, not every indicator is positive and some are downright worrisome.  Our economy and equity markets have been particularly perplexing and difficult to analyze since the financial crisis, to say the least.  It is for confusing times like these that we developed our investment system.

Introducing our dynamic derivatives portfolios for high net worth and institutional clients

Our Titan and Sidereal strategies generate returns by tactically harvesting the equity Volatility Risk Premium (“VRP”).  The VRP, in simple terms, is a measure of the extra price investors are willing to pay for protection against equity market losses, as compared to the price a rational investor with perfect information would pay.   The difference is positive most of the time – in other words, investors are generally willing to overpay for insurance against losses.  Our system is designed to capture this premium only during times when the probability of an abnormal equity market drawdown is low.  If our system determines the likelihood of an equity drawdown is unacceptably high, we move our client assets to cash the next day and wait for our system to indicate that conditions have turned more favorable. 

To harvest the VRP, both strategies will hold a short position in VIX futures contracts (or an ETF containing these contracts). These contracts are typically priced above the current (or "spot") level of the VIX index, with the difference reflecting, in part, the VRP.As time passes and the contracts approach maturity, their price must converge with the spot VIX index.If forecasted volatility does not appear, the futures contracts prices will fall to meet the spot level, and our clients will benefit.

VIX roll down chart.png

The above chart illustrates this process for the August 2016 futures contract.  As of July 20, 2016, the spot VIX Index was priced at 11.8 and the August 2016-expiry VIX Futures contract was priced at 15.5.  This price difference reflects, in part, the VRP investors were willing to pay for equity drawdown protection in the summer of 2016.  The chart shows the declining price of this contract each week, as equity market volatility failed to materialize.  Eventually on August 17, the contract matured at a price equal to the spot VIX index at the time.  Investors who shorted this futures contract on July 20 earned 2.7 points (from 15.5 to 12.8), or 17%, in the 21-day period from July 20 to August 17.

Of course, the performance of this approach will vary over time.  The summer 2016 data, while better than the average month, are not uncommon.  Bull and sideways equity markets generally present opportunities to harvest VRP, as do the recovery phases of bear markets.  Attempting to harvest VRP should be avoided during the onset of an equity correction or bear market.  The discernment of better or worse conditions for VRP harvesting is the core of Huygens’s tactical system that drives our strategies. 

We designed our system in 2016, after spending two years reviewing academic research and experimenting with live trades.  We studied 11 years of daily market data and examined our system’s hypothetical responses to it.  Over this time frame, in hypothetical tests our system recommended having exposure to the VRP-harvesting position 45% of trading days, and remaining in cash 55% of days.

Our Titan strategy is the purest expression of this approach; the Sidereal strategy combines it in a portfolio with a long position in 10-year treasuries, trading some potential absolute return for potentially more stable portfolio returns.