Logica Capital commentary for the month ended September 30, 2022.
Summary
The S&P 500’s habit of seemingly obeying a calendar schedule continued in September with another large negative month, ending at the very bottom of its accelerating decline into the latter part – and close — of the month. And once again, VIX/Implied Volatility reverted back to its behavioral norm for 2022, which is to say: a highly underwhelming move in the face of a substantial S&P decline. This was abundantly evident through most of September: where during the first -5% move down in the S&P 500, VIX registered a mere +1.48 points, and for the entire month, culminating in an almost -10% decline for the S&P, we saw a historically tiny gain of just +5.75 points for VIX.
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Commentary & Portfolio Return Attribution
Most aspects of our attribution for September were expected and straightforward. Our Macro Overlay continues to detract from performance, even at its meaningfully reduced size. Sector & Single Stock Calls did not provide their usual level of alpha in September, performing right in line with the S&P’s decline. As a usual outperformer, we consider this the natural ebb and flow of a sound process and inconsequential over a long-term review.
“Combine the extremes, and you will have the true center.”
– Karl Wilhelm Friedrich Schlegel
Continuing the trend of 2022, as mentioned in the summary above, we saw an even more disappointing VIX/IV reaction to a significant S&P 500 drawdown (red dot highlighted in green box below). In fact, it was one of the most muted responses ever for the monthly drawdown of around -9%. The 9 red dots in the below scatter plot represent the 9 months of S&P 500/VIX relationship thus far in 2022, wherein we can clearly see that the year-to-date lack of responsiveness has been quite significant.
Updating another chart we’ve been sharing nearly every month with the current YTD drawdown, we of course notice the same phenomenon in an even more impactful way. Amazingly, if we look to the green box below, which highlights the trough of the 2022 drawdown thus far, the 60-Day IV level was less than half its March 2020 level (27.32 vs 56.98) at almost exactly the same market decline. In fairness, the March 2020 decline was quick and powerful vs. the more extended and methodical behavior that has defined this year’s decline.
Similarly, every few months in our letters we have been keeping track of a couple of products/indices that use volatility as a hedge for long positions: one product through VIX Calls, and the other using S&P 500 Puts. Incredibly, we continue to see these products fail to provide much benefit (in the case of PPUT) and ironically, even provide negative benefit (in the case of VXTH). The point here is not to demean these products and/or their construction, but rather to highlight the incredible difficulty of long volatility given the behavior of this year’s declining market as compared to other recent crisis periods – and especially with regards to out-of-the-money (OTM) protection, as these 2 products employ.
– Beck Hansen
Another phenomenon we have seen in 2022 – which can partly be seen in the “Implied Volatility During S&P 500 Drawdowns” chart above, but even more clearly below – is that VIX/IV is failing to make new highs even though the S&P 500 is making new, materially lower lows. Looking specifically at the below comparison chart to understand the magnitude expressed, we see September’s S&P low approximately -15% lower than its March low, and yet VIX couldn’t even make the same high. In sum, a negative outcome from VIX over the second and third legs of the continuing decline.
Though maddening, this isn’t entirely surprising to those that trade volatility: in order for implied volatility to continue rising, typically a market must experience continually rising realized volatility. While we did see realized volatility consistently rise through the middle of the year, since then, we have seen it level off, and even decline. Essentially, around the middle of the year, market participants got used to the range of market action – to a large degree, desensitized to the moves or reactions – and thus implied volatility stopped making new highs. Moreover, not only did implied vol fall off, so did realized vol over the last few months. And all this despite the S&P 500 continuing to decline and make new substantive lows. The steady movement of realized volatility is illustrated in the Rolling 3-month Standard Deviation chart below.
The question we might ask is why so? In other words, why or how has the market so quickly gotten used to such dismal days coming out of an extended multi-decade bull market? The answer, in our view, is that what investors and speculators have gotten used to is the uncertainty itself. Said more technically, the requirement for Implied Volatility to spike, and continue to spike even higher, is increasing uncertainty – we saw this, for example, with Covid and with the ’08 GFC – where the question on people’s mind were pointed at what in the world would happen next; will the virus wipe out major populations, or in the case of the GFC, what 100-year-old institution will fall tomorrow?
In stark contrast, this year’s environment is consumed by slow economic change, wherein there is a fixed range of uncertainty, alongside a long road of monthly and/or quarterly numbers until we fully resolve how that range will play out. With all eyes on key inflationary indicators (GDP, CPI, unemployment, etc…) and the reaction of the Fed to those numbers, the range of outcomes are truly not that wide. At the extremes, the “shocking” numbers are over/under in basis point buckets, and the Fed reaction should or shouldn’t have (depending on your view!) been 25bps less/more. In sum, we are facing contained uncertainty rather than increasing uncertainty, and the Vol markets are complying.
– Michael Porter
With this in mind, conceptually, an ideal strategy in 2022 might have been to have some portion of long volatility along with a strategy that is outright short delta. While this may seem obvious, it’s important to note the differences in the approaches of strategies that fall within the “tail risk” bucket, as these can be anything from protection after the market is down 30%, to protection that kicks in immediately, to relative value spread trading, and everything in between.
For the “outright short delta” piece, the phenomena discussed above are primary reasons why trend following/macro/CTA strategies have fared quite well in 2022, as most that have done well have assuredly “trend followed” outright short exposure.
On that note, the above combination of long volatility with short delta is a primary reason why our Logica Tail Risk (LTR) strategy has provided a solid +9% YTD in 2022. LTR is a nice mix of outright short delta (via holding significantly greater negative delta exposure in substantively more long puts than long calls) as well as being long volatility. And as such, we can expect it to participate fairly soon after a drawdown begins, without requiring a meaningful implied volatility pop – as do some tail risk strategies – due to the fact that it purchases at-the-money (ATM) puts as opposed to far out-of-the-money (OTM) ones.
Of course, LTR isn’t the only way to thrive in a market like this, as plenty of diversified portfolios that combine long volatility and trend following have likely fared decently well.
