During 2012, my strategy performed as I anticipated. I changed my approach at the beginning of the year to hold a short Barclays Bank PLC iPath S&P 500 VIX Short-Term Futures (VXX) and long Barclays Bank PLC iPath S&P 500 VIX Mid-Term Futures (VXZ) position, which has turned out to be a good hedge against spikes in volatility. However, as I learned during the Greek debt crisis this past June, VXX can rise much faster than VXZ if the slope of the term structure is too steep.
Therefore, during periods when the average of the 5th and 6th month VIX futures is more than 35% above 1st month VIX futures, I will take only a short VXZ position. I will carry this strategy forward into 2013 as I believe it can properly balance risk and return under most circumstances.
Although 2012 hasn’t been a particularly volatile year -- the CBOE Volatility Index (VIX) hasn’t crossed above 27 in 2012 so far this year -- I expect 2013 to be more volatile as European countries continue to contain their debt problems and the U.S. likely begins implementing spending cuts and/or tax increases to address its own deficit.
This may impact the VIX future term structure as VIX futures typically enter backwardation during volatile events. Therefore, I anticipate VIX making a brief return to backwardation, in which case I would take a long VXX and short VXZ position.
Additionally, in my opinion the U.S. will enter a recession in the second half of 2013 due to:
- Expiration of tax cuts (Bush tax cuts and payroll tax cuts). Based on research performed by the Tax Policy Center, taxes are estimated to increase by more than $500 billion in 2013 if temporary tax provisions expire. This represents 3.2% of Q3 ’12 seasonally adjusted annual GDP rate of $15.8 trillion.
- Emphasis on reduced U.S. spending. The proposals for spending cuts haven’t all been finalized. However, my baseline view is that 2013 U.S. spending will be no greater 2012. If U.S. spending actually declines year-over-year, then this will further drag down the U.S. economy.
Given the anemic GDP growth occurring in the U.S., I believe a shock from increased taxes coupled with stagnant to declining government spending would send the U.S. into a recession in the second half of 2013.
However, if I am incorrect regarding the expiration of temporary tax provisions, then the U.S. will likely avoid a 2013 recession. Therefore, the outcome from December’s “Fiscal Cliff” discussions will have a large impact on my strategy in 2013. In either case, I believe I am well-positioned to capitalize on declining or increasing volatility.
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The investments discussed are held in client accounts as of December 6. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable.
Certain information contained in this presentation is based upon forward-looking statements, information and opinions, including descriptions of anticipated market changes and expectations of future activity. The manager believes that such statements, information and opinions are based upon reasonable estimates and assumptions. However, forward-looking statements, information and opinions are inherently uncertain and actual events or results may differ materially from those reflected in the forward-looking statements. Therefore, undue reliance should not be placed on such forward-looking statements, information and opinions.