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.

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.