China trade war headlines drove a volatile, whiplash August

Our strategies are designed to protect against two types of investment risk:

Headline risk: Same-day stock market response to a news item with implications for equity investors

Economic risk: Longer-term deterioration in economic activity or outlook that can impact equity market fundamentals and investor sentiment

Headline risk arises quickly and can dissipate quickly, while economic risk takes longer to reveal itself clearly and lasts longer with more severe impact. In August, trade-related headline risk emerged on three occasions, and dissipated quickly each time.

Analysts at JP Morgan and BofA noticed this and analyzed the daily market impact of the most prominent source of the headlines, President Trump’s tweets. The bottom line: his Tweets have significant market impact. Read more here: JP Morgan creates index to track Trump tweet impact; Bank of America: On days when Trump tweets a lot, stock market falls

Our investment strategies use portfolio composition designed to protect against headline risk, and use our volatility prediction & market stress indicators to switch to bearish positioning designed to protect when real economic risk emerges.

Because of the magnitude of August’s equity market responses to the trade-related headlines, both of our stress indicators switched to bearish positioning. Our equity market stress indicator switched back to bullish each time the headline risk dissipated; our derivative market stress indicator stayed bearish throughout the month, as shown below.

190916 Derivs indicator vs Short Vol Index.png

The outcome in August for our active derivatives portfolios is that they avoided most of the month’s drawdown and volatility.

Frequent bullish - bearish reversals such as those in August are the most challenging environment for our active equity portfolios. Our Capital Preservation portfolio, which is designed with the most cushion against headline risk, outperformed the Russell 1000 index in August. But our Moderate and Aggressive portfolios, which have less of that protection, underperformed it.

Huygens derivative market stress indicator helps protect against trade war related volatility bursts

In 2019 the volatility environment for our active derivatives portfolios (also known as our ‘short volatility’ portfolios) has rotated between two states:

  • Benign volatility as the U.S. economy continues to defy recession expectations and churns out steady, moderate growth - a very good scenario for harvesting volatility risk premium the way we do.

  • Bursts of volatility as surprise escalations of the U.S. - China trade war inject uncertainty into expectations for the future of the economy - a scenario which can quickly cause our derivative market stress indicator to turn bearish and wait for the volatility environment to improve.

In a previous post we described the gains our portfolios delivered in early 2019, after our derivative market stress indicator turned bullish in late January. The first of 2019’s surprise China trade war escalations came in May and hurt returns in that month before causing our portfolios to turn bearish until late June.

In June, volatility turned benign again and our portfolios were back to bullish and harvesting volatility risk premium. Then on July 31st, the U.S. Federal Reserve lowered interest rates as well as terminated early its balance sheet reduction program, known as quantitative tightening. The announcement linked the moves to providing the U.S. economy ‘insurance’ against future uncertainty, and this was generally interpreted as being linked to the ongoing U.S. - China trade war.

U.S. equity investors didn’t take the news well that day, perhaps anticipating that this would give the U.S. administration the green light to escalate the trade war. Our indicator turned bearish as a result, and our active derivatives portfolios exited the short volatility position at market close on August 1st.

That same day, the U.S. did indeed escalate the trade war with an announcement of new tariffs, and over the weekend China immediately responded by halting U.S. agricultural purchases and devaluing its currency. This drove a further volatility burst on Monday August 5th.

The below charts show the two short volatility indices that our active derivatives portfolios trade. When our portfolios are in the bullish positioning, they gain in value as these indices increase in value. On these charts we point out the days on which the trade war escalations were announced. The color coding of the lines also shows what was the state of our derivative market stress indicator at the time.

Mid-term volatility ETF (ticker: ZIV) traded by our robo-advisor active derivative portfolios

Signal vs ZIV ETF.png

Short-term short volatility index traded by our Titan and Sidereal short volatility portfolios

Signal vs Short Vol Index.png

At the moment, our indicator remains bearish, and due to its design will remain in that state for at least several more days.

One final observation - the early termination of the Federal Reserve’s quantitative tightening program could be quite significant and positive for the U.S. economy, stocks, and the volatility regime. Read here for our analysis of the impact quantitative easing and tightening have had on stocks.

How have our active equity portfolios performed over the past 9 months of stock market volatility? Quite well...

The first half of 2019 is a typical example of how our active portfolios can protect investors from behavioral biases that keep them from capturing stocks’ gains. 

Recall the situation coming into the year. During the brutal selloff of 2018’s 4th quarter, the Huygens equity market stress indicator was bearish for 54% of the trading days. All the financial news was bad. It was frightening:

Given the turmoil, investors might have been tempted to exit all stock exposure to wait for clear signs that the economy has strengthened before getting back in. 

Anyone doing that in 2019 missed a remarkable run and instead just locked in losses.  The signs of strength didn’t come until after most of the gains had been earned – as is usually the case. In January, there was no all-clear signal in the news as headlines stayed bleak:

Even so, the S&P 500 gained +7.9% in January.  The Huygens equity market stress indicator turned bullish within the first 5 trading days of the year, and as a result the most conservative Huygens active equity portfolio gained +3.7% while the most aggressive gained +5.6%.

In the months of February thru April 2019, economic news was mixed. An investor seeking unequivocal evidence of a strengthening economy still didn’t get it during these months, but equities kept recovering.  The S&P 500 gained 8.9% from February through April, and because our equity market stress indicator stayed bullish throughout, our conservative active equity portfolio was up 5.0% and our most aggressive was up 6.7% in the same period.

Then came May.  Headlines in the early part of the month finally made it clear that the previously expected 2019 recession had been averted:

But by the end of the month, news had turned sour again:

And the S&P 500 fell -6.6% in the month.  Our active equity portfolio composition protected against much of these losses: our conservative portfolio clients lost only -0.5%, while those in our aggressive portfolio lost only -2.1%.

Once again, an investor might have taken May’s selloff as a sign the economy was really faltering this time, and again this would have been a mistake. Our equity market stress indicator stayed bullish throughout, positioning our active portfolios to capitalize on the gains that were to come in June as the S&P 500 established a new high.

The industry-standard way to assess the benefits of an active strategy such as ours is a metric called “capture.” Up-capture measures how much of an index’s gains our strategy delivered, and down-capture measures how much of that index’s losses our strategy gave up.

The below table shows that over the past nine months (Oct 2018 thru Jun 2019) of heightened stock market volatility, all three of our active equity portfolios delivered much more of the upside than the downside of the equity indices they actively trade (click here for comprehensive performance tables and index descriptions):

*Past performance is not necessarily indicative of future results

*Past performance is not necessarily indicative of future results