Lockbox 2019 Year in Review

Posted on January 17th, 2020

December 2019 Market Performance

The stock market continued to display strength through the final month of 2019 despite some turbulence at the start. The early volatility was largely the result of increasingly aggressive trade rhetoric which likely spooked investors who still remember the holiday downturn in 2018. These tensions eased in the second half of the month and positive news helped fuel the Santa Rally to deliver a strong final month for a blockbuster 2019 in the stock market.

Trade tensions seemed to take a turn for the worse at the month’s opening as the US renewed metal tariffs on Brazil and Argentina, China announced an unreliable entity blacklist to include US companies, and Trump remarked he could delay a trade deal into the new year. Markets experienced volatility over worries that these tensions could cause the trade war to flare back up again, but things quickly improved with reports of progress in negotiations and encouraging gestures from China waiving some tariffs.

Stocks began to recover on these encouraging developments, but the Santa Rally really kicked into gear with the announcement that an agreement for the first phase of the trade deal had been reached in principle, and that the two sides were communicating on moving forward with signing. This spark injected more momentum to help the stock market maintain its bullish pace through the Christmas holiday and finish 2019 on a high note.

2019 Market Performance

Widening our perspective to the year at large, the market displayed strength from start to finish, surprising many market watchers, including ourselves, who had expected the stock market to have a much more restrained year. The reason for these weaker expectations was an array of significant economic and political risks that seemed to be converging in 2019, making the year seem like a rocky road for stocks. In the end, most of these risks ended up less impactful or significant than feared, helping the market maintain its momentum as it charged ahead for a very strong year.

Charts show three distinct markets throughout 2019. Early in the year from January through April, markets were in rebound mode, snapping back higher after the 2018 holiday downturn. Improving economic data and assurances that the Fed would be patient with interest rate hikes further fueled the market’s ascent during this period.

In the second period, we saw the market experience turbulence from May through September due to worsening trade tensions, a recession signal in the bond yield curve, and worries of economic slowdown in the latter half of the year. Despite the volatility, major indices still made new all time highs as investor sentiment stayed strong.

The end of year period from October to December saw pace pick up again as most of the market’s hurdles fell away and cleared the runway for the market’s end of year rally to take off. Diving deeper into the factors and events that moved the market throughout the year, three main trends emerge.

Domestic Economic Strength
At the end of 2018, the US seemed on the verge of an economic recession, one of the main fears that triggered the stock market’s dramatic dive during that year’s holiday season. These fears quickly revealed themselves to be overblown as strong employment numbers, positive year-end corporate earnings, and solid GDP displayed much more resilience from the economy than many expected and helped the rebound rally in first period of the year.

After the initial rebound period, fears of economic weakening began to creep back into investors’ minds. This was exacerbated by the formation of a yield curve inversion in bond markets, a historically reliable indicator of coming economic recession. Many interpreted this event as a signal that we would see significant economic weakness in the second half of the year. This investor unease contributed heavily to the turbulent markets in the middle period of the year.

As more data came out, the numbers did not bear out this pessimistic outlook as employment and other economic measures remained strong throughout the year. Third quarter corporate earnings season in October had been forecast to show a significant slowdown in economic activity, but turned out to be much stronger than feared, even despite fading stimulus from the 2017 tax cuts. The numbers demonstrated that for now, US economic activity continues to grow, helping to clear one of the hurdles for the market’s year-end rally period.

Interest Rate Easing
One of the major triggers for 2018’s market drop was concern that the Federal Reserve was hiking rates too aggressively — four rate hikes in a single year — which would put a damper on economic growth and corporate profits. Seeing the market’s reaction, Fed Chair Jerome Powell quickly softened his rhetoric, seeking to reassure investors they would be patient with future rate hikes. This seemed to appease markets enough early in the year to help sustain the first period rebound.

The inversion of the yield curve began to complicate matters towards the middle of the year. Initially, the Fed resisted calls to cut short term interest rates, reraising concerns the Fed’s stance was still too aggressive for the economic environment and fueling some of the market volatility during the middle period.

On this, too, the Fed quickly capitulated to market expectations and ultimately cut rates three times in 2019. After the third rate cut in October, Powell seemed to make an additional effort to suggest it would likely be some time before the Fed would begin to raise interest rates again. The news of this accommodative interest rate stance was timed perfectly to help kickstart the rally that took the major indices to new highs through the end of the year.

Trade War Negotiations
The big 800 pound panda in the room for the past few years has been the US-China trade war. 2019 began on an encouraging note with a tariff ceasefire in place while the two sides negotiated. This truce helped clear the air for the strong market rebound in the first period, and even stimulated it further after Trump postponed the ceasefire deadline.

Unfortunately, this detente again gave way to reignited tension in May with new tariffs on both sides, triggering the volatile middle period of the 2019 market. Tensions worsened through this rocky period with more rounds of tariffs between the two largest economies in the world.

In keeping with the other trends this year, the situation took a positive turn in October with the announcement of the first phase of a multi-part trade deal. This sudden improvement in the trade war situation was a massive boon to markets and was the main spark for the third period rally.

Other factors

In 2019, the convergence of so many factors from higher interest rates to fading tax cut stimulus to slowing economic growth to the US-China trade war posed significant challenges. Nevertheless, the stock market defied the majority of analyst predictions for the year with irrepressible strength, indicating a stronger market and more optimistic investor than many had counted on. And while the market did see its share of volatility, stocks kept hitting new highs throughout the entire year. In the end, a variety of factors did converge in October to clear obstacles and deliver another strong year in a now decade plus long bull market rally.

Lockbox Fund Performance and Strategy

While overshadowed by a great year for the stock market, our fund also delivered a solidly profitable year in 2019. Our portfolio returns did experience drag and briefly turned negative through the middle period of the year from trade war surprises and bond market shocks. However, the resiliency of our trading strategies were able to overcome these losses and deliver a positive return in line with Lockbox Capital’s goal of maintaining a consistent profit for the long term.

For the most part, our original trading strategy of selling equity option premium made up the bulk of our return for the year. Over time, however, we have continued to evolve our overall portfolio strategy to incorporate other trading tools. Last year in particular we made significant improvements in our technical analysis that enabled significant additions to our portfolio strategy that have already helped the consistency of our returns and that we expect will help boost performance going forward.

Options Trading Performance
In 2019, the primary components of our trading toolbox have been selling options on equity indices and options on treasury bonds through the futures market. Selling equity options has been the backbone of our portfolio since the fund’s inception and continues to be a strong trade. This was largely the case in 2019 aside from some jerkiness in market movement surrounding trade war events. Our hedge positions were able to absorb risk overruns and allowed us to continue trading this strategy consistently and profitably throughout the year.

Our strategy of selling options in bond futures is structurally the same but with a more gradual risk profile that often reacts very differently than the equity market. When volatile conditions give us trouble in equity markets or make them hard to trade, the bond market often does not feel the same turbulence. US treasuries in particular are generally more stable than stocks and experience dramatic movements much less commonly. By trading treasury bond futures alongside equity options in the same portfolio, we estimate we have cut our risk roughly in half compared to selling equity options alone.

Last May, one of these dramatic movements did occur when trade tensions reignited and renewed fears about future economic growth. This sparked a massive rally in bond prices as investors fled to safe haven investments, blowing up our bond positions. However, because of the flatter risk curve for our bond positions, the significant loss from this event did not overrun our risk thresholds, and we were not forced to close the trades and lock in those losses. We were also able to further ease the risk curve by buying futures to cover the positions.

To put the magnitude of risk improvement in perspective, without the ability to trade futures it would have cost $60 million in margin to cover the losses, forcing us to close the positions when the losses were most damaging. By using futures to control the risk curve, we were able to mitigate the margin cost to only $1.5 million, a vast improvement that makes all the difference and allows us to hold the trades until the bond market stabilizes. As volatility died down and market distortions faded in the second half of the year, the majority of our losses melted away. Ultimately, while this bond market shock did put a drag on our bond option strategy, our strong risk management was able to contain risk and minimize the loss to our portfolio for the year.

Improving Analysis Yields Wider Opportunities
In the past year we have made significant progress in our technical analysis of the market, giving our models better intraday accuracy and predictive power by reading the fund flow of institutional money. By being able to better predict when and where the top or bottom of a market is on a given day, we have gained an edge in optimizing when we open and close our trades. Armed with this data and our ability to make futures trades, we have been making adjustments to improve the profitability to risk ratio of our strategy, with particular focus on holding our positions for a shorter time frame with more defined risk. It has given us the ability to be more efficient option sellers when opportunities arise and reduces our exposure to market shocks.

Throughout 2019 most of our portfolio performed consistently well, although challenging conditions hit our bond market positions during the volatile middle part of the year. Our ongoing efforts to evolve and diversify our portfolio yielded stronger analysis tools that helped increase performance late in the year. Looking ahead this year, we see fewer obvious market flashpoints compared to last year, but still some lurking risks domestically with the impeachment and presidential election, as well as globally with the general degradation of international relations and increasing geopolitical conflicts such as the Hong Kong protests and heating conflict with Iran. Whatever 2020 holds in store, we are in a stronger position than ever to maintain a stable portfolio and deliver a strong consistent performance for Lockbox Capital.

December Lockbox Monthly Return After Fees*: Please Contact Us
2019 Lockbox Annual Return After Fees*: Please Contact Us
December S&P 500 Monthly Return: 2.86%
2019 S&P 500 Annual Return: 28.88%