Year in Review: 2022
Market participants continued to seek reassurances from the Federal Reserve (“Fed”) in December that they intend to pivot to cutting rates soon, but at its recent meetings, the Fed has reiterated its desire for lower asset prices and tighter credit conditions. As investors have historically experienced but seem all too eager to forget, the aphorism “Don’t Fight the Fed”, works in both directions. The S&P 500 Index (“S&P”) began the month with an initial rally but quickly reversed those early gains and continued to drop 9% in the aftermath of the Fed’s announced positioning. This wrapped up an abysmal year for the S&P, with the index declining 18.2%, the worst year for the U.S. equity market since the global financial crisis in 2008.Market participants continued to seek reassurances from the Federal Reserve (“Fed”) in December that they intend to pivot to cutting rates soon, but at its recent meetings, the Fed has reiterated its desire for lower asset prices and tighter credit conditions. As investors have historically experienced but seem all too eager to forget, the aphorism “Don’t Fight the Fed”, works in both directions. The S&P 500 Index (“S&P”) began the month with an initial rally but quickly reversed those early gains and continued to drop 9% in the aftermath of the Fed’s announced positioning. This wrapped up an abysmal year for the S&P, with the index declining 18.2%, the worst year for the U.S. equity market since the global financial crisis in 2008.
This quick rally and decline action seen in the S&P in December (and many times throughout this year) has allowed for the deep out of the money put spreads we use in the Directional Spread Strategy to quickly gain in value. These positions, which we generally initiate at a very low cost, can rapidly increase in price when the index has a sharp decline. Even though the CBOE Volatility Index (“VIX”) is reflecting levels lower than we believe are currently justified, we have been able to purchase these spreads to allow for a wide range of market oscillations and profit opportunities. The Directional Spread Strategy took advantage of this environment.
Optimism from market participants looking for soothing words from the Fed led to some pricing imbalances significantly out of the money calls. Buyers of these options that combine low premium with very high strikes are often using them as either insurance or margin-reducing trades. As we felt that the Fed would not deliver the “pivot” that many were anticipating, we viewed those options to be very overpriced. We were able to sell those positions and realized profits throughout the month.
While the losses in stocks this year have garnered most of the headlines, we continue to see fault lines in the fixed-income markets that are flashing warning signs. While short term interest rates did not climb much in December, the long end of the interest rate curve did, widening the spread between the 2-year and 10-year treasuries to extremes not seen since 1980. Historically, when this spread turns negative, that can be an indication that a recession is likely in the near future. It has now been negative since July 2022, with the spread continuing to grow. We contend that this has not been fully priced into markets and the prospect of a recession remains under appreciated.
This brings us to the long Vol component of the portfolio which has frustratingly been rather muted throughout 2022. With the VIX staying rather steady despite the big moves in the market, this trade has not had a chance to gain momentum. The genesis of this trade theory was to find a way to be long vol without the steady bleed that such insurance usually incurs. With our butterfly position structure, we have managed to maintain this exposure without paying for it, but we still wait for that capitulation moment where the trade should produce a significant return as it did in Feb 2020.
There is no doubt that 2022 will go down as one of the toughest years for strategies based around risk parity, balanced portfolio, and long-bias methodologies. With just about all asset groups ending down on the year, including bonds having their worst year on record, stocks their worst year since 2008 and even commodities reversing their early year gains, really the only place to hide was out of the market.
Through extremely hawkish language, the Fed again reminded markets that the fight with inflation was far from over with the threat of higher rates for a longer period. The following day the European Central Bank, Bank of England and Swiss National Bank all raised interest rates and stressed that their fight on inflation would continue. On Dec 20th the Japanese central bank surprised the markets by tightening monetary policy. This last event had not been anticipated at any level and caused major moves in the Japanese currency, stocks, and bonds. With each of these events Mustang saw new positions reduced from both the risk and tactical sides as markets again turned negative and volatility increased. The market dynamics were probably not helped by falling within the holiday period. With the exception of a JGB position the GTAP strategy had which was exited after the Japanese policy change, there was no activity in long or short interest rate contracts.
Commodities remained active and volatile albeit directionless with the exception of gold which gave a strong performance as it continued its ascent from the previous month and reentered the portfolio. Overall absolute exposure in active markets was low by historical measures as general market volatility remained extremely elevated, particularly within the commodities and currency sectors. The Mustang Fund, having a core portfolio based around these methodologies, navigated 2022 comparatively unscathed. This was in no small part due to the tactical component of the portfolio that again proved its ability to reduce exposure and help mitigate excessive negative tail events. With the tactical component of GTAP able to exit absolute exposure for prolonged periods of time, the program was able to avoid a majority of the major negative moves seen in bonds, stocks and commodities throughout 2022. While some of the other short term momentum strategies were able to capture early profits on these moves, the choppy markets that followed were not conducive to this type of trading. The Mustang Fund LP enters 2023 in a more defensive manner. The events of December may have set the tone for the coming year and help quell or at least calm dislocations that have seemed to exist between the markets and central bank mandates.
Mustang’s short term directional strategies gained from the downtrends, but the profits were offset by losses from the spreads as the emerging markets outperformed due to China’s U-turn of COVID policy. Regarding commodities, most instruments were in a range with somewhat of an upwards bias in general. The energy spreads continued to face challenges due to event risks, like for instance the oil price cap and the Keystone pipeline spill. These losses were partially offset by gains from the directional strategies on that front. On the currency side, BOJ’s policy change put pressure on the dollar which continued its downward trend, causing some minor losses. Overall, as we have seen for a while, the program kept its exposure low due to lack of high-conviction opportunities in the current market environment. We expect this to increase as the win loss ratios on trades continue to improve and the strategies start to leverage back into their exposure.
Trend following is a trading approach that seeks to capture gains through the analysis of an asset’s momentum in a given direction. It is an investment strategy that attempts to take advantage of long-term moves that play out in the market. In 2022, trend following demonstrated its importance as a strategy for traders looking to capitalize on market movements.
First, trend following strategies often involve buying or selling an asset when its trend reaches a certain price level. This implies that traders must pay attention to market movements to identify and capitalize on trends as they emerge. As such, trend following strategies are best used in environments where markets are highly liquid and move rapidly. In 2022 the talk of inflation along with disruption in areas vital to the grains markets caused large and sustained moves to the upside. We were able to take full advantage of these moves while other markets cratered like stocks and bonds.
Second, trend following strategies also involve taking profits at regular intervals, regardless of the trend’s direction. In other words, trend followers will often take profits when the trend reaches a certain level, regardless of whether the trend is continuing in the same direction or is about to reverse. This requires the systems we employ to be looking at trends across various time frames. A difficult transition for a trend following strategy is the shift from one major trend to another. This occurred as the commodity complex by and large gave up their gains from earlier in the year but did so in a much less linear fashion. By taking profits along the way the system can keep the majority of its gain while managing losses as the market searches for direction.
Third, trend following strategies must manage their risk carefully. This is because trend following is a high-risk, high-reward strategy, and losses can quickly mount up if not managed properly. As such, for a strategy like we use in the Triple-T (Trade the Trend) to remain successful in 2023 we will continue to evaluate and constantly assess risk profile to be able to manage the exposure to the markets. Lastly, trend following strategies require investors to be patient. As trends can take time to develop, strategy needs to be prepared to wait for the right opportunities before entering the market. This is especially true in 2023, when markets are likely to remain volatile and prone to sharp swings. By being patient and waiting for the right moment to enter the market, the strategy can maximize their chances of success. In conclusion, trend following will remain an important trading strategy in 2023 as global markets will likely continue their volatile and active nature.
Disclaimer – Past performance is not necessarily indicative of future results. The risk of loss in trading commodity interests can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The high degree of leverage that is often obtainable in commodity interest trading can work against you as well as for you. The use of leverage can lead to large losses as well as gains. In some cases, managed commodity accounts are subject to substantial charges for management and advisory fees. It may be necessary for those accounts that are subject to these charges to make substantial trading profits to avoid depletion or exhaustion of their assets.