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.

Huygens equity market stress indicator quickly returns to bullish positioning despite noise and confusion surrounding presidential election

The weeks since early November 2016 are emblematic of a period when a quantitative indicator of true stock market stress can be most helpful to protect investors from their psychological biases.  You may recall that many respectable economists predicted severe and immediate financial market panic if Donald Trump won.  

On election night, at roughly 2:30 AM when Fox News first called the election for Donald Trump, Walt received a call from a close friend (who is however not a Huygens client).  “Is there any way I can sell all my mutual funds before the market opens tomorrow?” he asked.  At the time of that phone call, U.S. equity index futures were dropping precipitously.   

The panic quickly subsided. Within a day of the election, our market stress indicator turned offensive and has stayed in that state ever since, and as a result our strategies have captured much of the ensuing strong equity market run. An individual’s natural response would have been to expect volatility to resume, and therefore to wait on the sidelines for a better market entry point. Our system recommended otherwise, to our clients’ benefit.

Earlier in 2016, we pointed out that equity market stress, as measured by rolling 12-month volatility of daily returns, has been continuing its long decline from the 2008-9 global financial crisis, despite having reached a recent minor peak in February of 2016.  The Kansas City Federal Reserve Bank’s index of financial market stress, which combines measures of stress in multiple financial markets including equity, debt, and foreign exchange markets, illustrates this well:

KC Fed stress index.png

Huygens market stress indicator correctly maintained bullish positioning in the quarter & captured stocks' gains, at a time when recession seemed imminent but never arrived.

Despite current jitters over the upcoming elections, the U.S. economy continues to improve, albeit slowly.  The Conference Board’s Leading and Coincident Economic Indicator Indices both signal that a downturn in economic activity has not yet arrived.

Source: The Conference Board

Source: The Conference Board

At the core of our strategies is a system for determining when to have offensive or defensive exposure to U.S. equities.  While there is certainly benefit to a system that can move to a defensive position before an equity market selloff has reached its bottom, it can be equally beneficial for that system to maintain an offensive positioning when emotions might otherwise lead a human investor to play it safe.  Thus our system has maintained its offensive positioning for all but four trading days this year, capturing the Russell 2000’s strong recovery since February.

In past client notes we have commented on our study of regimes in financial market behavior.  The below chart graphs rolling 12-month standard deviation of daily returns to illustrate long-term behavioral regimes in the U.S. large-cap equity market.  Volatility has been in a continued decline since the 2008-9 financial crisis.  Recent bursts of volatility in 2015 and early 2016 were driven mostly by fears of aggressive central bank tightening, not by true underlying economic weakness.  Now that the tightening has not materialized, volatility has resumed its long, slow decline.

S&P realized vol.png

As you know, the Huygens Market Stress Indicator system monitors equity market volatility daily in order to react to any sudden and severe changes in equity market sentiment. The general lack of change in our system’s positioning in 2016 seems consistent with the ongoing (if slow-moving) economic recovery, and the large-scale decline in equity market volatility.

Like you, we wait with some anxiety to see what early November brings.Regardless, we continue to monitor equity market stress daily and react accordingly.

Huygens market stress indicator correctly stayed bullish at quarter end as US Central Bank interest rate stimulus cushioned US stocks against Brexit volatility and ongoing earnings softness

The story of the quarter is straightforward.  In our previous two client notes, we noted the marked underperformance of the Russell 2000 small cap index relative to the S&P 500, but commented in our Q1 2016 note that the worst of this divergence was likely over.  We pointed out that it was driven by two factors: the Russell 2000’s overexposure to energy, and the S&P 500’s overexposure to corporate buybacks.  With oil prices recovering and stabilizing since February 2016, and with the volume of corporate buybacks declining in 2016, the Russell 2000 outperformed the S&P 500 by 6% off the early February bottom.  See the chart below.

Russell SPLV SP500 chart.png

In addition, the S&P large cap low-volatility index also outperformed the S&P 500.  This index tends to overweight high dividend-paying stocks.  At the start of 2016, the U.S. Federal Reserve Bank (FRB) had signaled it would likely increase interest rates 4 times in the year, but several indicators of economic growth, including inflation, job creation, and wage growth, were low enough to force the FRB to reconsider.  Its current messaging is that it may only raise interest rates once or twice, and as a result dividend-paying stocks have outperformed the broader index.

We finally also note the very brief burst of volatility surrounding the UK’s decision to leave the EU.  Our market stress indicator correctly remained offensive during the whole episode, and equity market performance quickly validated that call.

In sum, several things went our way this quarter.

Is a recession already underway? Decreasing total US market cap + flat large cap stock prices + falling small cap stock prices = corporate buybacks the main support for S&P 500 stocks

The nearly flat performance of U.S. equity indices and of our Pilot strategies in the first three months of 2016 belie the full story of the quarter.  The divergence between the Russell 2000 and the S&P 500, which we first mentioned in our Q4 2015 note, continued and accelerated.  The below chart shows the relative change in the equity indices our strategies use versus the S&P 500 over the past two years.  During most of this time, the Russell has lagged the S&P 500.  The lowest-volatility names of the S&P 500 - generally defensive stocks such as utilities and consumer staples - performed best. 

Russell SPLV SP500 chart.png

In mid-2015 it appeared the small-cap vs. large-cap performance gap was closing, but instead it widened further, with the Russell underperforming the S&P by 11.0% since June 29, 2015.  More than half of that gap occurred in the fraught first six weeks of 2016.  We believe the ongoing divergence has been driven by falling oil prices (disproportionately negative for small-caps), and corporate buybacks (disproportionately positive for large caps).



The above and following charts, from Yardeni Research, show that energy is having more impact on the small-cap universe than the large-cap.  The S&P 600 is a U.S. small-cap index, essentially comprising the 600 largest companies of the Russell 2000 index that we use.  The charts show the relative expected earnings contribution of each industry segment to the earnings of the overall index.  At the start of 2014, energy was by far the largest contributor to small cap expected earnings, but in 2015 that contribution declined dramatically and turned negative.  Energy earnings expectations briefly improved in mid-2015, but then deteriorated further into negative territory through Q1 2016. 



Energy was also a drag on the S&P 500 large-cap index over this time, however its relative contribution to index earnings wasn’t as large to begin with in 2014, plus large-cap energy companies have managed to keep their earnings positive.

Now consider the Thomson-Reuters U.S. equity mutual fund flow data below. It shows that aside from 2013-14, investor capital has been steadily flowing out of U.S. equities, with the outflow accelerating to an annualized rate of $66B in Q1 2016.

Equity fund flows.png

Consider also that, according to the World Bank, U.S. equity market capitalization shrank by 4.8% in 2015, from $26.3 trillion to $25.1.  Corporate buybacks, a mainly large-cap phenomenon, help explain what has been supporting the S&P 500 index as market capitalization declined and investor capital flowed out of the market.  According to the below Factset Research chart of trailing-twelve-month U.S. buybacks, the annual value of corporate share buybacks has remained near its pre-financial crisis peak, even as earnings have declined.  These buybacks simultaneously put upward pressure on equity prices, and return capital to shareholders reducing market capitalization. 

Source: FactSet

Source: FactSet

Projecting these two trends forward, it appears that the worst of the large-cap / small-cap divergence may be over.  If S&P 500 earnings don’t rebound from their ongoing decline (light green bars in the above chart), companies may choose to deploy more of their net income into growth projects rather than return it to shareholders through buybacks.  Regarding energy, WTI crude oil prices have recently risen 43% since February to $45.92 / bbl, a level not seen since December.

This may not mean that the economy has turned a corner.In fact, the below Yardeni Research chart shows that when S&P 500 revenues have declined for multiple quarters as they have recently, a recession was already underway. Stay tuned.



Risks increasing and rewards decreasing in post-monetary stimulus environment

Our strategies’ performance in 2015 was driven primarily by three factors:

  • Rapid sentiment changes and reversals driven by Federal Reserve interest rate decisions

  • Outperformance of the S&P low volatility index relative to the S&P 500

  • Underperformance of the Russell 2000 small cap index relative to the S&P 500

R2K SPLV SP500.png

Huygens’s strategies are all designed to participate in the economic growth experienced by smaller U.S. companies (via the Russell 2000 small cap equity index) while giving some protection against economic downturns.  Our system is designed to minimize trading by riding out smaller index drawdowns, and switching to defensive positioning when conditions are more consistent with a severe decline.  Our Pilot and Mariner strategies trade some of the potential absolute gain of our tactical Russell 2000 exposure for cushion against smaller Russell drawdowns.  This cushion is provided by adding to the portfolio the defensive large-cap equity exposure of the S&P low volatility index (SPLV).

While both indices are highly correlated with the broader U.S. equity market, their smaller cycles tend to be negatively correlated.  The above chart of 2015 U.S. equity index performance shows that in the first half of 2015, the Russell 2000 was the best performing of the three indices, presumably because investor expectations for growth remained high.  In the second half of the year, investor sentiment deteriorated and the defensive SPLV index outperformed the Russell 2000.  The two indices worked together as intended to cushion each others’ fluctuations in our Pilot and Mariner client accounts.  However because the strategies have more Russell exposure than SPLV, the Russell dragged the overall portfolios down relative to the S&P 500.  Our Navigator clients have only the tactical Russell exposure, so its impact was more pronounced for them.

The August / September volatility event, which we discussed in more detail in our 3rd quarter 2015 client note, also contributed to our underperformance relative to the S&P 500. The central bank stimulus of the 2012-2015 period created an investor sentiment environment that depended almost entirely on Federal Reserve Bank actions and commentary rather than on fundamental performance of the overall economy. The volatility event’s rapid onset and equally rapid departure were both driven by expected and actual central bank activity here and abroad. Market reactions to these were quicker than our system is designed to respond to or protect against. The result was that, during this event, our system delivered the protection against volatility and further declines that it is designed to provide, yet it gave up performance relative to the S&P 500 on the first day of the event and the last due to the rapid sentiment changes and large market moves on those days.

Outlook for 2016

2016 is the first year since 2008 in which there is not some form of emergency Federal Reserve economic stimulus (either zero-interest rate policy or quantitative easing) in place at the beginning of the year. We designed our system around the assumption of independent market participants each making their best effort at rational price discovery, and we are hopeful for a return to this process in 2016. What might this mean for equity market performance? We find the following simple analysis enlightening.

Modified Sharpe.png

The modified Sharpe Ratio measures the average return an investor earns per unit of volatility experienced over time.   This chart shows that in the post-crisis era, the absence of central bank stimulus resulted in less return per unit of volatility than stocks’ pre-crisis long-term average.  In other words, without stimulus, risk increased and reward decreased.  We believe this will continue in 2016 as more of the stimulus-era gains are given up while fundamentals-driven price discovery continues.

Declining S&P revenues and profits driving equity market stress

The primary story of the third quarter was the August / September volatility event, which coincided with a period of global economic weakness and uncertainty.  The below chart from Yardeni Research illustrates the challenge faced by the U.S. economy, and therefore the U.S. equity market, in 2015.  The OECD index of U.S. leading economic indicators (the blue line) has been predicting a slowdown for most of 2015.  At the same time, S&P 500 revenues per share (the red line) have declined in 2015 from their year-ago levels and are on track to do so again in the third quarter, according to Factset Research’s most recent Earnings Insight report.



In late August, these factors plus a host of others – concern over a potential Federal Reserve interest rate increase, a stock market selloff in China and the Chinese government’s resulting surprise currency devaluation, persistent declines in commodity prices – all contributed to a burst of volatility in U.S. equities. 

The chart below shows that our Market Stress Indicator switched to Defense at market close Friday August 21.At the time, the S&P 500 was in the throes of its steepest decline since August 2011. In fact at market open August 24th, when our portfolios repositioned, equity indices were already down substantially from Friday’s close. Our Indicator remained in the Defense state for 30 trading days, the longest such period since we introduced our system four years ago. This period represented a classic investor sentiment regime shift from one of optimism to a regime of pessimism and fear, characterized by much higher than average daily volatility and abrupt reversals in equity market direction.

Signal vs S&P 500.png

During this 30-day period, the S&P 500’s daily volatility more than doubled to 1.83%, from 0.75% in 2015 through August 20th.  Over the past ten years, this level of volatility has only been seen during the market selloff of 2008-9, and the steep S&P 500 corrections of 2010 and 2011. 

Market downside volatility abruptly ceased on October 2nd, protecting the S&P 500 from further declines past its 12.4% peak-to-trough decline reached at the start of the volatility event in August.  The catalyst was most likely that morning’s disappointing Non-Farm Payrolls (NFP) report, which convinced investors that the Federal Reserve was unlikely to raise interest rates before its December meeting. 

In our view, this last point illustrates the U.S. equity market’s ongoing dependency on stimulus measures, and the risk of further volatility once these measures are unwound.  The October 2nd NFP report was disappointing in several areas: job creation was shown to be slowing, hourly wages declined, and average hours worked declined.  Such a report would normally depress equities due to its implications for future economic growth.  However, by making it difficult for the Federal Reserve to justify raising rates, in this instance it quieted volatility and ignited a recovery in U.S. equities that has continued through October, a continuation of the “bad-news-is-good-news” equity cycle induced by ongoing stimulus.

At the end of the third quarter of 2015, the Russell 2000 stood at 1100.69, a level it first reached nearly two years before, on October 17th 2013.Sideways trading in U.S. equities continues, without a meaningful break one way or the other.We wait along with you for the return of a trend.

Huygens system particularly relevant in confusing rare environment of narrow trading range, low volatility, few up days, and declining company revenues and profits

During the second quarter of 2015, our market stress indicator remained consistently in the offensive portfolio state.  All U.S. equity indices traded within a historically narrow range and ended the quarter essentially flat.  In fact, the narrow S&P 500 range in the first six months of 2015 placed the period in the lowest decile of all 6-month periods ranked by trading range going back to 1953.  Such a narrow range is rare, but not predictive of future returns.  In the middle 1990s the S&P 500 broke out of its narrow range to resume the strong bull market trend of that decade, but in 2007 the range breakout occurred to the downside with the global financial crisis.  What is clear is that periods of such low volatility are anomalous and not representative of the normal state of the equity market.

S&P 500 past 6 month trading range.png

The first half of 2015 was also notable when ranked on the basis of percent up days.  The chart below shows the S&P 500 returns in all six-month periods since 1953, grouped into deciles on the basis of the portion of days in the period with positive S&P 500 returns.  The relationship shown makes intuitive sense: those periods with fewer positive S&P 500 days are more likely to have had worse total return than those with more positive return days. The January to June 2015 period is notable because, on the basis of percent up days, it ranked in the second worst decile (marked in purple).

S&P 500 past 6 mo return.png

Nearly every period in that decile going back to 1953 had a negative S&P 500 return, and the median return in that decile is -4.7%.   The first half of 2015 was one of the very few 6-month periods of the past 60 years having such a low percentage of up days, and still delivering a positive return for the S&P 500: +0.20%.   

By any measure, the S&P 500 and other U.S. equity indices continue to trade within a remarkably tight range.  It remains to be seen which direction equities will break when the trading range normalizes.  Our indicator system monitors equity market stress on a daily basis, and when economic indicators are uncertain, as they are now, the downside protection it affords can be especially valuable.

As of this writing, the second quarter earnings season is in full swing.  Factset’s July 24th Earnings Insight predicts that when all S&P 500 companies have reported for the April to June quarter, the results will show blended revenue and earnings declines of 4.0% and 2.2% respectively, relative to the second quarter of 2014.  Given such performance, the stable condition of equity markets remains surprising.  In the past two quarters, revenue and earnings declines were limited to the energy sector.  However in the second quarter, according to Factset’s predictions, utilities and materials also experienced revenue and earnings declines.  Furthermore, blended S&P 500 revenues are expected to continue declining through the end of 2015.

As you know, we monitor market and economic circumstances regularly to confirm that our products are performing as designed. We believe it’s when economic indicators are uncertain, as they are now, that the downside protection afforded by our approach can be especially valuable.