365 Days of Volatility Discussed on Schaeffer's Market Mashup podcast

Breaking down bull and bear market cycles

Managing Editor
Apr 1, 2021 at 10:00 AM
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On the latest episode of the Schaeffer's Market Mashup podcast, we discuss Covid-19's 12-month impact on the markets. On the one-year anniversary of the coronavirus pandemic hitting Wall Street, Patrick is joined by Joe Tigay, Portfolio Manager, Equity Armor Investments and Cboe's Senior Options Institute Instructor, Kevin Davitt to chat about the last year, and what's to come. Using as many as Opening Day baseball puns possible, they talk bull/bear market cycles (3:40), the utility of VIX hedges, (16:10) and what could spook investors in 2021(25:09).


Transcript of Schaeffer's Market Mashup Podcast: April 1, 2021

Patrick: It's the last day of March; opening day is tomorrow a little over a year ago. The VIX index roared to a new all-time closing high up at 82.69. Exceeding any closing level during 2008 and 2009. And even though the S and P 500 experienced its fastest 30% drop in history at just 22 trading days. It's good to note that the stock market has recovered from every previous bear market. Today, I try out Joe Tigay portfolio manager of Equity Armor Investments and CBOs, senior options Institute instructor, Kevin Davitt, to discuss the volatility market landscape. What the VIX can tell us, how to protect your portfolio. And we try to squeeze in as many as baseball ponds as we can. Let's take a listen. Joe, welcome on first-time caller. How are you?

Joe Tigay: Thank you very much for having me. It's very good to be here.

Patrick: And basically my co-host at this point, Kevin Davitt, how are you, man? Good to see you. Last time we talked it was I think September 9th.

Kevin Davitt: I'm doing wonderful and it's great to be back. I look forward to it.

Patrick: Great, great. Let's jump right into it. You know, it's I know it's a tough act to summarize an entire year in a few short sentences. Kevin, is it safe to say that global markets have regained their footing from the past 12 months?

Kevin Davitt: That is a tough act, but I think it was Shakespeare and Hamlet where they point out that brevity is the soul of wit. So let's try to get witty, the S and P 500 looking back experienced a technical bear market between February 19th and March 23rd of last year. Now, as many people know it was the sharpest 30% decline in history, and it was followed by the fastest bull market in history. So we had a whiplash market and it might sound fairly obvious to point out that markets to use your words have regained their footing. When the S and P 500 is up 77% from the March lows of last year. That's the largest 12 month advance for the index since it was introduced in 1957. And you'd have to go back to the mid-1930s for a larger move on a rolling one-year timeframe. So the bellwether US equity index is 17% higher than the feb 2020 highs. So on face and in price terms, the market is on solid footing. I would argue that there's potentially microstructure elements under the market that might indicate future issues, which I imagine we'll get into. What do you have to say about it, Joe? 

Joe Tigay: Yeah, I would say that's a spot on, it's been a year we won't forget to say the least and to say that the market has recovered is an understatement. I think I'm concerned about some of the underpinning of ethics of the market, but just where you're sitting today. Certainly the markets are at ease with the pandemic situation.

Patrick: Okay. And what is the moment Kev, you can take this or what is the defining moment that characterizes a new market cycle in the first place? So investors can start to pinpoint whether in looking forward or looking back.

Kevin Davitt: Yeah, we love to pinpoint dates, right? I think that's a natural inclination. There's probably a couple of ways that you could answer it from a technical perspective. The kind of 2009 to 2020 bull market run ended in March of last year. Now, from a purist standpoint, if you get a 20% move lower in the broad market on a closing basis, textbooks will refer to it as a bear market. 

Patrick: Yes.

Kevin Davitt: But as I alluded to a minute ago, this bear market was unlike any other, the last two technical bear markets ended in March of 2009 and October of 2002, those took 517 days and 929 calendar days to play out. The 2020 version took 33 calendar debts. So back to your point, if your primary concern or risk is price, then a new bull market began on March 23rd of last year. And it's just over a year old; Joe and I are both kind of focused on derivative markets and volatility, which is a critical component with respect to things like futures and options, those tools. And I imagine we'll get to those or to viewing the market through adapt lens shortly, but from a letter of the law standpoint, bull and bear markets are defined by 20% closing moves higher or lower.

Patrick: Wonderful, wonderful, Joe, what do you got?

Joe Tigay: When it comes to just that stretch we are obviously focused on the VIX a lot and the VIX sometimes is a leading indicator or an indicator. And I noticed when the market bottoms and the VIX peak at the same time that can be a change in sentiment. Of course, that happened in March, of course that happened a lot faster than historically it's happened. But when we saw the market recovering and the VIX making a lower, low and the market making a new relative high you know, and I'm talking about the VIX coming down into the fifties and the market coming off of that 35% drop off., you know, down to only 25% that we could have said was, okay, now we're in a new era. But again, that's only, it was only known in hindsight. We didn't know it when it was actually peaking. So that's just kind of the uncertainty of it and what happens with volatility.

Kevin Davitt: Yeah, but when you point out, I think that's an interesting point you bring up the VIX index on a closing basis peaked last year on the 16th of March and technically the S and P didn't find a bottom until about a week later. So you could argue that leading indicator worked last year, there isn't any silver bullet, but if you have that on your screen and on your radar, that can be valuable the next time something unforeseen occurs.

Patrick: That's a very good point. That's a very good point. Well, let's go straight into volatility since I know both of you are chomping at the bit here. The volatility market seems to be revealing a higher volatility regime now. To start what does that mean and why is it important to distinguish Joe you can go first and then Kevin can finish.

Joe Tigay: Yeah, so it's all relative. We need to remember last year we had the VIX peeking out in the eighties slowly when it came back down and now we're kind of settling in where the low side of the range is, you know, maybe the high teens to the low twenties is kind of where the VIX is, is bouncing around lately. And in the past year, that's low, but if you go back in the last bull market, that's kind of high. And, you know, as we sit here today, as we're recording this, the S and P 500 is just a few points away from an all-time high, and we still have the VIX in the high teens. So this is signaling to me that there's a new normal for the VIX.

The new normal is we're going to be having a relatively higher volatility. And the reasons for that for me are that you know, the economy and the stock market are not quite on the same page. A lot of the economic buildup has been simulative, money handed out by the government that continues to be the case. We have a stimulus package coming out soon and the market of course loves that, which sets up this weird dichotomy, where we give high praise to the earnings ratios and the market's pricing that in because they're expecting the economy to be stimulated by the money going in and the economy has yet to catch up.

So that creates a margin of error for these companies which are, is really narrow, they have to hit their earnings. And then the second thing, which is very volatile is the low interest rates and I know they're rising as we speak, but there's still historically very well. And when we have low interest rates that, that leads to higher volatility because when we have a small interest rate percentage, [unclear 09:01]  rate point move is a larger percentage move when it's lower and the move send to do the same, it's just higher percentage. So that creates more volatility in the, throughout the whole equity market. 

Kevin Davitt: So I take absolute, I would echo Joe's points on kind of the market here and now to your question about sort of what does higher volatility mean, or how might you distinguish that? I'd take maybe a little bit broader perspective and point out that as Joe did realized, and implied volatility levels remain higher than pre pandemic on both a short and longer term basis. Now, for those that are maybe unfamiliar realized volatility is based on historical data. So to what extent were underlying prices moving over a specific timeframe in the past, implied volatility measures are forward-looking and there we're talking about something like the VIX index. 

So the value is backed out based on an option pricing model, but in short, it's a dynamic estimate of potential future volatility. And Joe mentioned that bellwether measure for equity volatility being the VIX index. And I would contend that higher volatility markets can provide both opportunities as well as risks. And that might be obvious, but thinking about it that way helps me, the timing and flexibility elements embedded in options have become really widely embraced. I say this often, but volatility is a constant, and it's one of those words where the connotation and the denotation of the word volatility are often distinct.

And that volatility is neither inherently good nor bad those measures ebb and flow. But as Joe pointed out the uncertainty as we look forward, there's considerable unknowns, and there's tremendous information embedded in things like the Vicks, and then just rounding it out like forecasts are imperfect. But they're super useful and options can give us great insights into what the market is collectively forecasting with respect to future uncertainty, right? So I mean, if you want to make it a little more tangible, if the forecast calls for wind and rain and falling temperatures, we're talking about opening day for baseball tomorrow, right. And it's 65 and sunny. Now that might impact your planning and choices about clothing in the future. And that information alone can be super valuable.

Patrick: Yeah, I hate to run with that analogy, but I think that's why you always layer up, you know, you always wear a long sleeve shirt, maybe, you know, something to protect you either way, give you the flexibility. I don't know, maybe I ran too far with that, but Joe, I want to talk about you...

Joe: I love it.

Patrick: I want to talk to you about your expertise here a little bit. How does all of this impact a client's risk management decision?

Joe Tigay: Yeah, so we're sitting in the area, we're expecting more volatility. So we have a few choices for protection to the downside. Of course, the traditional method my advisors usually look at is a balanced blended portfolio. You have equities and you have bonds historically, that's provided production to the downside. You have bonds which give you a cushion when the equities go lower, your bond portfolio goes well, and lately that's not been providing any downside protection. It's actually adding risk. We're seeing equity risk to bonds; to rates specifically so, looking at volatility is a really attractive space for me in order to provide downside equity protection. Now, it's also kind of matured but the volatility space has matured to a point where it's a lot easier to do that for the average investor.

There are VIX futures now, people can invest in VIX futures or they can invest in funds, which do that for them like my own. And, but before there were VIX futures, it was a lot harder to get involved in impure volatility. You could buy puts in the S and P 500, in index options that would be fundamentally different than a VIX future though, because first of all, those of course expire regularly. But when you're buying volatility in sporting, since the S and P 500, what you're effectively doing is buying the difference between the implied vol and what the actual realized wall will be, okay. So you're making a bet that the realized vol will be more than the applied vol you purchased.

When you're owning VIX futures you can, you are actually just saying, okay, I expect this future to go higher because you're just buying something that has a set price, rather than depending on the actual volatility of any index. So it's more of a pure volatility play and that of course has only been around since 2006 back before 2006 if you remember all the way back then we were on blackberries instead of apples, or actually I had a flip phone. I remember very well an ESPN flip phone I was the biggest nerd, but I loved it. Anyways, the VIX futures allow us a pure play in a volatility, which moves very highly negatively correlated against the market.

And it allows advisors like myself to be aggressive when the markets lower, Kevin talked about volatility being a potential benefit. I have two portions of my portfolio, the equity portion, a volatility portion, when the market's lower; I can harvest the returns on my volatility portion. Put it back into my equities, which are now lower, which getting inside baseball and the options world that's trading long gamma, which allows me to buy low and sell high in the market.

Patrick: Very interesting, very interesting. I love that. Yeah, I, my dad promised me he was going to get me the ESPN phone if I got straight A's and yeah, I haven't seen the phone.

Joe Tigay: I wasn't worth it.

Patrick: I do want to or Kevin, did you have anything you wanted to add or?

Kevin Davitt: No, I'm just a big fan of the analogies and Joe's pointing out that correlation risk where it has been fairly strongly positive between fixed income markets and equity markets of late and historically a demonstrably negative correlation between volatility as measured by VIX or VIX futures and the equity markets. So I think that's a key thing to be mindful of.

Patrick: Okay, so I want to talk a little bit about VIX hedges and their applications making sense in a higher vol regime. Joe is it easier to time compared to index puts and then Kev you can follow up and fill in the blanks.

Joe Tigay: Well it's more purely a negative correlated asset. Of course, like I said, you don't have to worry about the implied versus realized volatility. There still is the same challenges rolling and I think it takes, in either case it takes an expert with some hands-on knowledge of the instrument. Of course, you have big futures, which move independently of the actual index. So it takes some knowledge of the seasonality of it, the timing of it. But to be able to do a daily rebalance is, which is what I do is very tricky to do with an option position. You got a very wide bid-ask spread to get it on and off is not as simple. With the VIX futures they're very liquid, very deep. It allows for a clean daily rebalance in the VIX futures world.

Patrick: Okay. Kevin, anything to add?

Joe Tigay: So I'd be careful and I think Joe did a great job of pointing out that none of this is easy, right. And so really understanding the tools and their utility and perhaps your own limitations is important here. And then as I'm inclined to often do I sort of take a step back and think about it from a broader perspective. And I would argue that hedges make sense, period, and kind of independent of the overall regime. I think the regime might inform your sizing and potentially the monetization of those hedges, which Joe hinted at already and I might elaborate on. So from a big picture standpoint, hedges are designed to lose money that's reality, but it's one that many market participants and particularly new ones are kind of low to a net.

And I understand it. We want to grow our account balances and then there's this desire to want to time the market. And I'll be vulnerable, I have been in the markets for the better part of the past 20 years, and I've never top tech sold the market or bought the bottom, right not ever. So if you have considerable money and that can vary depending on your situation in life, in the market, a shock, like a pandemic or a financial crisis from 12 years ago or 20 years ago, if you're a little bit older like Joe and me can really, really impact your bottom line. And so, protection in the event of a big move can it's a little cliché, but keep you in the game and something Joe hinted at that I would absolutely reinforce that protection can enable you to allocate capital back into equity markets when they're discounted, as opposed to being reactionary, which is a much more typical behavior when kind of the proverbial house is on fire.

So again, understanding that full cost benefit analysis and if we went back to that weather forecast ahead of baseball, like if you know that in climate weather is a distinct possibility, you plan ahead. Like if you go to Ireland or Scotland without a rain jacket that's your fault, right? So I think hedges just makes sense, period, or to the reds opening day. You better dress up.

Patrick: The analogies are flying fast and furious today. And I really do like what Joe said about the reallocating that articulated a lot for me. 

Joe Tigay: Yeah, like maybe if I can clean up better on that the bases are loaded here. We, we're talking about how this hedge is considered to be an insurance and most people are accepting that insurance will cost money. And again, I'm going back to the implied versus realized trade here, if the implied, or if you buy something implied [unclear 20:41] realize it's more than the implied, it actually will be profitable. And the way that options are priced is that there's a potential, or a move every single day. So you have a passive trade, you're more likely to have a big drag and having that insurance costs you money.

If you're a passive hedge, if you have an active hedge where you're trading daily, your chances for profit and making that insurance cost money, it costs less money or even be profitable are much greater. So that's why I think it's very important to consider this active trade where we're expecting, we're not expecting the VIX make money over time because we can hold it just like equities. We do expect equities to make money over time, but we expect the VIX to go higher and come back down lower and then revert to the mean. That's why you need to be active on it; you need to be adding when it drops. You need to be selling it when it goes up.

Patrick: Very sound advice. I want to kind of take a page out of Kevin's book here and take a step back. As of right now, I just had it pulled up, let me see here. VIX is sitting at 19.21, so that's a pretty low level right now. So wouldn't that indicate a sense or return to quote unquote normal levels? I know Joe, you talked about a new normal would you want to explain that a little bit?

Joe Tigay: Yeah. So the VIX has been trending lower for some time. It took a while to crack that 20 mark. There's nothing magical about it, but it seems stubborn to want to fall below there. And we're still trending lower now, but as we are low, we still are having these mini blips back above 20, 22, 23. So I expect more of that to happen because there's still more shaking out of the economy that needs to happen. We have, you know, the growth names, which are at a tremendous year for the past 12 months, we're still catching up to them in value so, while that shakes out, we're going to have a little bit of under some uncertainty there. And at the end of the day we have more uncertainty than normal right now. And the essence of volatility is uncertainty. We don't know what's going to happen, you know, a week ago. I, you know, I would not have predicted that a ship blocking the Suez canal is going to cause like a big impact in you know, global trade. And I would not have predicted a pandemic, you know, 14 months ago either. So there's just a lot of unknowns and right now, given the state of the economy where we expect it to be really good, it's not good yet. That's just, we're sitting in a spot where it's, there's a lot of unknowns.

Patrick: Kevin. 

Kevin Davitt: I echo most of what Joe had to say, I guess the deep only, or reinforce that it does seem like we're returning to some version of normal. In my opinion, that'll likely be characterized by a slightly higher baseline, which again is echoing what Joe had to say for volatility measures we'll likely continue to see spats of what I characterize idiosyncratic volatility, whether it's Suez Canal or whatever. The next one that happens to be just like you see in kind of any pre 2020 market, we remembered these huge, huge moves, but in the interim, there's a whole bunch of kind of noisy volatility moves. And then sort of pointing out one, the VIX index is back around 19 as of today, but the VIX index is not tradable. It's an index, it measures and then the VIX futures, which Joe spoke about already and manages those days to day are on average, or they remain high relative to kind of a more normal VIX around 19 market. So, that's indicative of S and P 500 index options pricing in that potential for greater future swings, up and down is worth pointing out the volatility is not directional. And so understanding that or having a better understanding of that entire ecosystem, I think can be very beneficial.

Patrick: Well said, well said I think we're going to, about to wrap up here. I want to close with one broader question about sentiment, Kevin, you can take this and then Joe can bring it home, but regarding the market sentiment, what, is really spooking investors and what can participants expect broadly from volatility for the rest of 2021?

Kevin Davitt: It's a great question. It's one that I think legitimately millions and millions of people are asking themselves in the wake of the past year, the woulda-coulda-shouldas. So from my perspective, and again, this is just my opinion. It seems like inflation and that relationship to interest rates in the US and globally will continue to be a fairly paramount concern. I'd point out that there is a relationship or that that fixed income markets and that equity markets are kind of competing for a finite pool of capital. And so at what point, or is there an inflection point between interest rates, whether the ten-year moves through 2%, does that, incentivize people to move more capital into bonds? I don't know the answer to that, but I think it's one that concerns a number of investors, or maybe on a, like on a really basic level. 

We've seen the prices for things like, food and energy move markedly higher in the past couple of months. Now, from an inflation standpoint, those are stripped out of your core CPI calculations that the fed points to. But they impact your pocket book, my pocket book, Joe's pocket book. At what point does that become a meaningful drag on potential spending, which is what drives the economy forward, consumer spending. Maybe well behind that would be moves in housing like if that becomes a stretch for too many people. And then the one last, I think very legitimate one, which we skirted around the issue would be valuation. So Joe pointed out that looking ahead, we're expecting a recovery. And part of that would be much stronger earnings in the next year. Otherwise, the broad market PE ratio would be unusually high. And if that has to meet somewhere in between, what that might mean in terms of a draw down, I think is an interesting one. What about you, Joe? What do you think about my worries? 

Joe Tigay: Yeah. I think that's pretty true. There and the way that I always think about it also is that there's always a list of worries though. Just like you said, and they're always pressing, they always feel really important. We're always really excited about the next jobs; we're always really excited about the next FLMC meeting. And at the end of the day, my view doesn't usually change. I think if you have a long-term view, I think the market will be higher, [unclear 28:08] five to 10 year horizon but while the market's going higher. I'm pretty confident periodically almost once a year, there's going to be a big volatility of that. So my view is I always want to be in the market and I always want to have a hedge now, right now going back to what's currently on my mind is that and this is just like a lot of other people I'm talking to, is that they're worried on the market might go up 30% this year and there'll be in cash. That's one worry, they don't, and that’s just as bad as being down for some people. And then you also have [unclear 28:42] worried that there's really high D ratios is always things that we're always worried about and the market's about to crash. So, all things are possible and that's why for me being invested in the market with a hedge is my favorite way to invest and that is why I can sleep easy. 

Patrick: Very well said.

Kevin Davitt:  You're talking about the proactive versus reactive if you're able to manage both of those things well put. 

Patrick: Very well said, very well said. Joe, Kevin, I hate to finish with one more analogy, but, and it’s the easy one, but you guys hit it out of the park. I can't thank you enough for coming on and you know, Kevin; you're returning guests, so thank you again. And Joe, hopefully you can come back.

Joe Tigay: Alright. 

Kevin Davitt: You put it on the team Patrick. These are 70 mile an hour fastballs. Even some guy on the Reds could hit that out of the park.

Patrick: Yeah, there we go. We can log off right now. Alright, cheers guys.


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