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.

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

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