Indexology^® Blog

Investors are rightly concerned about the future course of equity prices, especially in the context of the Federal Reserve’s bruited tapering of QE3, and it’s obviously true that equity market volatility has increased sharply since the beginning of May. Rising volatility typically means lower stock prices — the correlation of the S&P 500 and the S&P 500 VIX Short-Term Futures Index is -0.78. If volatility continues to rise, what can equity investors do to diminish its impact?

An increasingly popular solution in recent years has been to use a variety of low volatility strategies as an alternative to traditional cap-weighted indices. Low vol indices are designed to attenuate the movements of their parent index, in both directions — they typically go up less when times are good, and go down less when times are bad. But although they may go down less when times are bad, they still go down. For the month of June (through the close on Friday 6/21), the total return of the S&P 500 was -2.23%, versus -1.38% for the S&P 500 Low Volatility Index. Low Vol did what it typically does in bad markets by diminishing the parent index’s decline.*

There’s another approach to dealing with increasingly volatile equity markets. That approach is to own a long position in VIX futures — in other words, to regard volatility as a diversifying asset for the investor’s equity portfolio. In this sense, volatility is analogous to an insurance policy. The problem is that when you don’t need it, volatility can be very expensive insurance. For the year ended 6/21/13, e.g., the S&P 500 VIX Short-Term Futures Index declined by -69% (while the S&P 500 rose by +23%).* Holding a permanent or static portfolio weight in volatility is likely to be an expensive exercise.

The S&P 500 Dynamic VEQTOR Index attempts to cheapen the implicit insurance cost of owning volatility by altering its relative exposure to VIX and the underlying S&P 500. (Hence the name: VEQTOR = Volatility and EQuity allocaTOR.) When it appears propitious to increase exposure to volatility (for example, when it’s in an uptrend), VEQTOR holds more. At other times, VEQTOR’s vol exposures can be quite modest. The combination of two negatively-correlated asset (equity and equity volatility) can produce a smoother, hedged pattern of returns, especially in comparison to a fully-invested equity index. For example, for the month of June (through the close on Friday 6/21), the total return of the S&P 500 Dynamic VEQTOR Index was +0.24%, compared to the S&P 500’s -2.23% decline.*

Volatility is uncomfortable for all equity investors. But it’s also unavoidable. Those who seek to lessen its effects can try to own it (with VEQTOR) or reduce it (with Low Vol). Both choices have their risks, and both have their potential rewards.

* Examples are provided for illustrative purposes only. Past performance is no guarantee of future results.

Since roughly the beginning of May, U.S. interest rates have been in an uptrend, with the 10 year Treasury note ending last week at a yield of 2.5%. Equity markets, not surprisingly, have reacted by weakening, especially in last week’s trading.

Some of us of a certain age will admit to a degree of bewilderment at this, since a 2.5% 10 year rate would have seemed ridiculously, if not unattainably, low for the vast majority of our working lives. Why are markets reacting so negatively to what, in most historical contexts, would have been considered a very favorable rate environment?

The answer lies in the distinction between high rates and rising rates. A 2.5% Treasury yield is unquestionably not high by any reasonable historical standard, but rates have equally unquestionably been rising for the last two months. When rates are stable, whether high or low, the equity market is priced to reflect their stability. When rates change, the equity market adjusts to reflect the change. As with many other phenomena in economics, it’s not the level of a variable that makes the difference, but the variable’s rate of change.

Stable rates, other things equal, enhance the stability of equity returns. Rising rates, if indeed they do continue to rise, may present a continuing challenge.

Friday afternoon and the markets survived the Fed’s pre-announcement of QE3’s demise.  The big move was in the yield on 10 year treasuries, now about 2.5%, the highest since August of 2011.  VIX broke through 20 the first time this year. The stock market is down but has only retraced its steps back to late April or early May.

Consensus outlook for the Fed is reductions in QE3 bond buying beginning in the fall and the complete end to QE3 sometime next summer.  Interest rates are expected to rise, but there is little agreement as to how much.  The Fed’s upbeat forecast for the economy of 3%-3.5% GDP growth in 2014 with continued low inflation is seen as a bit optimistic.

And now…

First, just because the Fed chairman Bernanke spent Wednesday afternoon explaining what the Fed expects and what it is likely to do, don’t believe it is locked-in or committed to a time table.  The Fed can, and frequently does, change its plans if the economy and markets change. One line many economists attribute to John Maynard Keynes is, “when the data change, I change my mind; what do you do?”  Whether or not the Fed economists are Keynesians, they do change their minds when the data change.

Second, if the Fed’s forecast turns out to be right – stronger growth, no inflation and less unemployment – the stock market’s prospects should look a whole lot better than in the last few days.  The market can advance when interest rates are rising, especially of the cause of rising rates is faster economic growth.

Third, not only is the rest of the world watching, and worrying, about the Fed; the Fed is also watching the rest of the world.  One wild card may be China where there are lots of signs that economic growth is slowing and short term interest rates spiked earlier this week.  Were Chinese economic growth to falter we would hear renewed concerns about the economy and speculation about continued quantitative easing.

Source: Data for the chart are daily data from 12/31/2012 to 6/21/2013 as of 6/21/2013. 10-year Treasury yield is from Bloomberg, S&P 500 is from S&P Dow Jones Indices. Past Performance is no guarantee of future results.

All commodities in the S&P GSCI and the DJ-UBS CI crashed on June 20, 2013, losing 3.1% and 3.0%, respectively, after the Fed declared the U.S. economy was expanding strongly enough for the central bank to begin slowing the pace of its bond-buying stimulus later this year.  This is generally bad news for commodities since historically as the U.S dollar strengthens, goods priced in dollars become more expensive for other currencies. The historical negative relationship between the U.S. dollar and the S&P GSCI is shown below.

In addition to the generally inverse relationship between the U.S. dollar and commodities, there may be another overbearing consequence to the quantitative easing, reducing the incentive of the risk-specialists to fill the needs of commercial hedgers.  It is based on the systematic response to whether the monetary policy works or does not work. In other words, the “Risk On – Risk Off” behavior of this market may be dominating individual commodities fundamentals, like the unexpected inventory rise of crude oil.

Thursday was a day where it seemed the “Risk-Off” was overshadowing fundamentals. The S&P GSCI and DJ-UBS CI Gold, Silver, Coffee, and Nickel, fell 6.4%, 8.3%, 4.8% and  3.5%, respectively for the day, and each are now bear markets for 2013.  The S&P GSCI Gold, which recorded its biggest daily loss ever on April 15, 2013 of -9.3%, has not had two single day losses of this magnitude in the same year since 1980.

And waiting is exactly what the markets did for most of Wednesday, right up until the 2 p.m. press release from the Federal Open Market Committee (FOMC) meeting. Following the press release, markets sold off on confirmation that economic activity has been expanding at a moderate pace. As the release stated, “Labor market conditions have shown further improvement in recent months, on balance, but the unemployment rate remains elevated. Household spending and business fixed investment advanced, and the housing sector has strengthened further, but fiscal policy is restraining economic growth. Partly reflecting transitory influences, inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable.”

The selloff in the S&P 500 resulted in an immediate 10 point drop, followed by a number of attempts to recover, finally ending the day down 22.88 at 1628.93. Bond prices also fell as the yield on the 10-year Treasury rose 8 basis points (bps) on the news. The previous day’s 2.18% close was quickly eclipsed as the 10-year note finished the day at 2.35%. The S&P/BGCantor 10-20 Year U.S. Treasury Bond Index gave up 1.20% and is now down 4.24% on the year. The importance of an index like the 10-20 year index, with 10.07 years of duration, is that it’s an indicator for mortgage rates, which are benchmarked to the 10-year Treasury.

The FOMC decided to keep the target range for the federal funds rate at 0%-0.25%, and to continue purchasing agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month. The Fed’s previously stated plan was to continue the stimulus as long as the unemployment rate remained above 6.5%, with an inflation goal of 2%. Today’s press conference hinted that a 7% unemployment rate would be an acceptable level to start curtailing quantitative easing. Hints of a possible early start to tapering took its toll on the credit markets as well. The S&P U.S. Issued Investment Grade Corporate Bond Index was down 0.72% for the day, led by the Atmos Energy Corp. 4.15% January 2043 bond, whose daily total return was -0.03%. High-yield bonds did not sell off quite as much, as the shorter duration (4.97 years) index dropped by only -0.09% for the day as measured by the S&P U.S. Issued High Yield Corporate Bond Index.

The S&P/LSTA U.S. Leveraged Loan 100 Index was unchanged for the day and is down -0.26% month-to-date. When comparing the returns of both high yield bonds and senior loans, the performance of senior loans has better weathered the current volatility in interest rates.