Posted by & filed under Hedge Fund Performance, Investing, White Papers/ Thought Pieces.


Article contributed by William H. Warshaw, Founding Partner and President, Warshaw Asset Management, LLC

The month of February was all about volatility. Within the first 6 trading days the SPX lost -8.60%, only to recoup 5.15% of the losses by month end. The record levels of short volatility positions in VIX related ETFs were forced to cover shorts as it spiked from an intra-day low of 12.50% on February 1st, to an intra-day high of 50.30% on February 6th, before closing at 19.85% on February 28th. The primary catalyst for the mean reversion in volatility levels was a rise in the 10-year treasury yield from 2.40% at the start of the year to 2.95% during the month. I have been pointing out since October that interest rates are artificially low, and we are susceptible to a jump volatility event with record amounts of short volatility positions across asset classes. Trump’s tax and spending policies, record levels of budget and trade deficits, Central Bank’s reduction of liquidity/rate tightening and possible trade wars are leading us on a path to higher levels of volatility and has likely brought an end to the 30-year bull market in bonds.

Warshaw believes volatility increases and decreases due to macro, fundamental and quantitative catalysts, not solely because it is high or low. Mean reversion tendencies are best taken advantage of through a diversified approach of buying and selling volatility when in a transitionary period. The mean reversion that occurred during the month represents the first period since Q4 2015 thru Q1 2016 that there were opportunities to buy and sell volatility, implement relative value structures to take advantage of the backwardation across durations and implement skew profiles as implied volatility surfaces steepened. Unlike the previous mean reversion period, the current dynamics of rising interest rates, reduction of Central Bank policy measures and risk premia have provided a floor on volatility levels across asset classes. As predicted, we have transitioned to a moderate volatility environment. I expect spikes to a higher volatility environment and an occasional drop to the upper band of a low volatility environment. Historically, this has been an optimal backdrop for our diversified approach as market takers of non-correlated profiles across asset classes.

An important macro catalyst for volatility to remain in a moderate environment is the lack of economic growth even with unemployment near record lows. The final GDP for Q4 2017 was 2.50%, well below estimates by the sell side and the White House. Manufacturing, retail spending and real estate indicators have been slowing, and it is being reflected by the Atlanta Fed GDPNow Index. The index was targeting Q1 GDP growth at 5.50% on February 1st, by February 16th it had decreased to 3.20% and on February 26th it was 2.60%. The sell side does not want to discuss an economy that does not support valuation levels as they continue to grasp for straws from the tax plans benefits, the mantra that higher interest rates are not bad for long risk assets and that consumer confidence is near record levels, as was the case in Q1 2000 and Q3 2007. As we have been discussing, all three arguments lack merit as; the tax plan results in only approximately 40bps of GDP growth annually as the average tax rate for SPX companies was already near 20% before its passage, higher rates have a negative effect on risk assets valuations and earnings when not accompanied by economic growth and a historical chart of the SPX and NDX in Q1 2000 or Q4 2007 depicts how poor an indicator the consumer sentiment index is. I would argue the only reason for the bounce from the sell-off was for technical reasons as we hit the 200-day moving average for the SPX and corporate buybacks ended their earnings black-out period.

We are only at the tip of the iceberg for volatility across asset classes as normalization of rates and reduction of liquidity/bond buying programs by Central Banks are becoming a global mandate. The overabundance of short volatility positioning in VIX related instruments resulted in the perfect storm for the mean reversion of equity implied to exceed realized levels in greater proportion than any other asset class. The historical relationship of interest rate to equity volatility has become positively correlated and with Central Bank’s easy money policies being abandoned, will likely be a valuable tool for volatility forecasting. This is supported by the Merrill Lynch Move Index and VIX both having bottomed intra-day in November of 2017 at 43.97% and 8.56% respectively, and then both spiked in February 2018 to 72% and 50.30% respectively. The targeting of listed equities implied volatility during the summer of 2017 and the recent initiation of ETF index volatility in December/January were both beneficiaries of the mean reversion. It is also important to note that a diversified approach benefits not only when equities dropped at the onset of the month but also during the rebound in prices as the magnitude and velocity of the price moves resulted in further dislocation of the quantitative relationship between implied and realized volatility levels.

AMZN, the poster child for investing and a targeted name from FAANG is a perfect example. AMZN’s stock price did not initially drop with the market and then rebounded to all-time highs by February 26th. Implied volatility increased 4.53 points for the targeted 1-year at-the-money duration and 8.44 points for 3-month, 10% downside duration. I specified the 3-month, 10% downside contract, because that would be the relative value skew structure of preference to sell as an offsetting option contract versus the 1-year option and implement a risk reversal profile. The arbitrage opportunity existed to sell either the longer dated Vega or to take advantage of a steeping skew surfaces and still maintain a long Vega/convexity bias. The velocity of the move upward for the final two weeks of the month permitted one to capitalize on the same arbitrage that has been in place prior to February, where intra-day realized exceeds implied volatility. The profile is agnostic as to whether volatility or prices increase or decrease, rather it is dependent upon the standard deviation price movements and the dislocation it creates in the option market.

TrimTabs, who tracks corporate buybacks, has published data indicating buybacks increased by $218bln since the passage of the Trump tax plan. Ironically, corporations are not focused on using the monies primarily for increasing wages or business investment as the President predicted. Of that amount, $153.70bln was announced in the month of February breaking the previous record of $133bln in April 2015. One should not take comfort in this as a put or floor on the market as it is amongst the largest capitalized stocks and it is a short-term remedy for lifting the indices. These same practices occurred in 2000 and 2008 as corporate buying elevated market indices.

Why then would a company be buying their stock so aggressively at a CAPE of 34.08? My opinion is that; there are no inherent growth prospects in their lines of business, it manipulates EPS higher, it promotes Wall Street’s bullish enthusiasm by reducing the size of the float and it allows insiders to sell at higher prices. Many don’t realize that buybacks were illegal until 1982 as the SEC considered it to be a manipulative practice by corporations. Select Democrats are voicing the need for legislation, but it is highly unlikely that Congress would opt to remove the punch bowl and vote in favor of free market principles. The elephant in the room remains that even with buybacks, one cannot expect risk assets to continue their meteoric rise since the financial crises as the two primary catalysts; Central Bank liquidity/asset purchases and record low interest rates are being removed from the system.

Many portfolio managers have never traded a pre-financial crises market as they have relied upon Central Bank, corporate and Wall Street manipulation. As predicted in the January letter; short sellers, CTA’s/trend followers and long/short strategies have underperformed as price swings and volatility has taken its toll. I expect style drift and chasing benchmarks to further impact returns negatively. Channel checks with prime brokers indicate various long/short managers are maintaining 60% net long portfolio exposures and leverage has not been reduced. Recent media articles are noting concerns regarding overvaluations for private equity investments and short volatility exposures at pensions, endowments and corporations. The CIO of Hawaii’s pension fund was fired last month for excessive short put and call positions. The level of greed and lack of risk oversight created by over-crowded risk exposures will continue to create volatility and opportunity. We have yet to have a widening of credit spreads but with rates likely rising and the economy not exhibiting robust growth, I am watching this closely as a catalyst for further jump volatility.

The previously discussed similarities for equities to 2000 remains overwhelming, not only from the standpoint of quantitative relationships, but also for the lack of earnings at the TSLA’s of the world and companies with real earnings that are at valuations only exceeded during the Dot Com bubble. Long risk positioning will continue to encounter headwinds as the norm of large swings in price and volatility both to the upside and the downside will be met with illiquidity and increasing correlation levels. I therefore would suggest a diversified approach to managing a volatility portfolio during this transitionary market environment.


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