The Big Conversation
Episode 80: Is stock market protection too expensive?
This week we look at the unusual activity taking place under the hood of the equity market. Some of this has never been seen before, but should we care, if central banks have our backs? Recent history highlights the risk of air pockets, but are put options now too expensive?
The Big Questions
In this new section, we answer some of the recent questions from viewers about how central bank balance sheets are impacting the Euro and what are the implications for EM bonds resulting from a stronger US dollar or higher US yields.
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[00:00:00] US equity markets are near their all-time highs, but there is some very unusual activity going on below the hood. Some of this can be explained by renewed interest in demand for equities, where US household exposure is at an all-time high of total assets, having now surpassed the previous dotcom peak at the end of the first quarter of this year. And this will probably have increased again when this quarter's data is released. In this week's episode of The Big Conversation, we look at equity markets that appear to be running on fumes, but so far have refused to roll-over. Policymakers may have changed the framework, but that doesn't mean that risks have fully disappeared.
[00:00:37] It's hard to be bearish on US equities in this environment. The fear of higher bond yields has receded for now, whilst earnings haven't mattered for a number of years, indicated by the increasing disconnect between them and the level of the S&P 500, which is now more extreme than during the dotcom bubble. Meanwhile the share buybacks have returned to record levels. That said, however, we are now entering the buyback blackout period where companies can't purchase their shares in a window that lasts for two weeks before a company reports its earnings until 48 hours after the announcement. Second quarter earnings season unofficially gets underway in the second week of July, so many buyback programmes will be on hold. The US dollar remains the clearest threat, but it really needs to break the key resistance level of 92.75 On the DXY, and then move quickly into the old range. But it's not the level, it's the speed that matters and even then the bigger risk is for an unwind of the rotation trade rather than a broader based pullback in the market. Fiscal and monetary support is expected to protect the worst of the downside, but investors will still have to navigate unexpected air pockets and tolerate drawdowns that exceed 10 percent. During the next few weeks, the buyback blackout means that U.S. equity markets could be more susceptible to negative growth surprises. If that means lower bond yields, it will be supportive of tech and growth stocks. Policy error has also crept into the mix. We can't really call the Fed comments at the June FOMC as hawkish in absolute terms, but they were in comparison to previous statements. As usual, however, Fed speakers have since been playing down those hawkish aspects. But the genie is now out of the bottle, and other global central bankers will also be thinking about reducing accommodation, though that's still a huge difference from actual tightening. Market breadth, one of the indicators of internal health of an equity market, has certainly been extremely unusual in recent sessions. Jason Goepfert of Sentiment Trader has noted that never before have we seen more stocks in the S&P 500 at one-month lows when the S&P 500 is less than one percent of an all time high. Therefore, there's no data to tell us what might actually happen next. But he also notes that when fewer than half the stocks are above their 50 day moving average, when the S&P is making all time highs, then there has been a decline in that market every time since the mid 1920s, and he expects there will be more warning signs from breadth indicators in coming sessions. However, we still have to ask whether policymakers have now created a new normal that overrides those historical precedents. We know that a handful of stocks have been generating the bulk of this market's performance, and that's nothing new. Only this week, Facebook joined the one trillion-dollar market cap club, reiterating this concentration. Other indicators have also been recently making new records. The CBOE Skew Index, measuring the difference between the volatility of way out of the money puts versus way out of the money calls has also made a new all-time high. The volatility of out of the money puts is much higher than the volatility of the out of the money calls. This indicator doesn't have a great predictive relationship with the underlying equity market, the S&P 500. We have seen spikes in this index prior to key inflection points, but they are not great timing devices with the spikes often occurring well in advance of those turning points. But nonetheless, this is a significant record reading in this index. So skew can increase, because of an increase in put volatility or a decline in call volatility. Often near those previous highs, it was that drop in core volatility that caused skew to historically increase. Today, it is stubbornly high volatility in those lower strikes that's keeping that skew elevated. Therefore, if everyone is already buying protection, how much downside will we actually see? In reality it means that the deep downside is probably already protected. But those who want protection just below current levels, well those options will look expensive. The risks are therefore, that many investors won't want to pay for expensive protection at the moment. The one-month historical volatility on the S&P, and that's what the index has actually been doing over the last month, is around 9 percent. But the 95 percent put below the current spot level has an implied volatility of around 18 percent. Now, that gap closes a bit for the three-month version, but it remains expensive. It also means that risk reversals, where people sell calls to fund the purchase of a put, are going to be very unappetising at this point. To buy the 90 percent put to the end of September this year, you would need to sell something like a 103.5 percent call to make that a zero-cost structure. It's hardly an attractive proposition giving away everything over 3.5 percent on the upside to buy protection that only begins to kick in once the index has fallen 10 percent. What many institutions will be looking at in this sort of environment will be stock replacement trades. This is where a long equity position is sold and replaced by a long call position. That's got a similar payout structure to owning an outright put against the index. But in this scenario, they are locking in that relatively lower volatility on the upside. Rather than buy that 90 percent put, funded by a 103.5 percent call, they would rather switch from a long S&P position and own the 3 month, 103.5 percent call for less than 1 percent, give or take. And these are very indicative numbers. The implied volatility for this call is just over 11 percent. That's about in line and maybe even slightly under the 3 month realigns volatility of around 13 percent. And this position reduces downside risk and gives them exposure to any rally above 4.5 percent from these current levels. And these issues of skew are not just confined to the US market. There is steep skew in many European and Asian markets, too. But in some of these cases, the stock replacement trades are optically even more interesting over the longer term. In Europe, where there are negative interest rates, the forward value of the curve is below current spot levels. The forward is a combination of interest rates which here have a negative impact and then subtracting dividends. In previous episodes of The Big Conversation, we've highlighted that the 5 year at the money call on Eurostoxx 50 cost around 8 percent. Many institutions are looking at these strategies because it keeps their powder dry, although if that cash is deposited in current accounts, it will also be subject to a compounding negative interest rate. That capital will need to be deployed elsewhere. The Eurozone banks also have a downward sloping forward curve. The 5 year at the money call cost slightly more than those for the Eurostoxx 50 at around 9 percent. Optically there is an excellent risk-reward to be had by switching out of long banks and into longer dated long calls. Over five years the owner of the calls compared to being long the underlying bank index would be better off if the index falls below 85 and they would still participate in a rally above 103.5 on the index. So institutions should be looking at stock replacement strategies rather than buying put protection in this current environment. But then the next question for many institutions would be 'why bother'? Policymakers, especially the Fed, like to come out with soothing comments every time the market starts to wobble. But one of the key elements beyond their control will be the performance of China. China is central to the reflation trade and they've been taking their foot off the accelerator. New orders have rolled over after a tepid recovery from last year's shock. Currency strength has been more than offset by the rise in commodity prices, and this has been impacting corporate margins. China's Citi Surprise index has fallen deeply into negative territory. Although emerging market equities don't follow every gyration of this index, it's clear that EM equities struggle when Chinese data is surprising to the downside. Can EM equities continue to hold their ground here? Back in the US, despite all the small business demand for jobs, few are actually hiring, whilst many people are actually quitting. Yes, there's a skills mismatch, but there is also a mismatch on salary. The difference between what companies want and what they are doing is quite stark. Companies that are offering jobs are not offering wages that are attractive for employees, which is also why quits have also race to a new high. And the transfer payments, which have kept US personal income at extreme levels in recent months, are now starting to be shut down in some states. Admittedly these are generally the states with lower populations than the regions on the western and eastern seaboards, but the change is coming, and income growth will go into reverse. After an incredibly volatile 15 months, personal income growth appears to be returning to the long-term trajectory, and the year-on-year change is now flat. Affordability of many durable goods items is at historic lows and this will be a drain on savings. What is absolutely clear is how unusual this recessionary period has been. If an alien surveyed the Earth, it would be convinced that recessions were good for wealth and that risk assets perform best when growth was on the back foot. US net wealth has exploded during this recession. This should be reflationary. But corporates are again hoarding cash rather than lending it or doing buybacks rather than investing capital. If low growth is good for risk assets, perhaps higher growth is bad for them. The recent decline in bond yields should therefore be comforting for the longer-term picture. But as we've outlined before, that doesn't mean we won't have any air pockets along the way. Volatility is relatively cheap across many assets at the headline level, but the actual protection costs significantly more in the equity market. Currency volatility still at the low end of its range, which means that dollar hedges, hedging against the surge in dollar strength, makes sense and some institutions will be looking at risk reversals there. These have swung in favour of puts on the euro, so investors will have to pay up for these, but presumably if the dollar declines, then risk assets will move higher and offset those costs. In the equity markets, stock replacement trades are being preferred to outright put protection, because of those costs of skew. The coming buyback blackout period means that markets will be susceptible to more shocks. The month-on-month gains in the S&P have been steadily declining since last year's initial rally. This is a sign of a maturing market, but the market internals suggest that a short, sharp shock is not out of the question. And then it would depend upon how quickly the Fed can spring back into action with support. Put protection is not cheap, but stock replacement trades are attractive, and not everyone will be able to ignore their trading stops.
[00:11:10] In The Big Questions, we'll look at some requests from the comment section of recent episodes of The Big Conversation and try and provide some explanations about what might be happening. And the first one is from a couple of weeks ago from Kartik asking why the euro is going up when the ECB is expanding its balance sheet at a faster pace than the Fed, and therefore, why is the dollar going down when the Fed is expanding its balance sheet at the slowest pace? Now, this is fairly contrary to the perceived wisdom of dilution - more dollars should mean a weaker dollar and vice versa. But the opposite is happening. Now many people think that just printing dollars is a sufficient condition for a weaker dollar, but not if other central banks are also in the game. But it still doesn't explain why this dynamic appears to be working in reverse today. Over the last few months, we can see that when the ECB balance sheet is expanding faster than the Fed balance sheet, the euro has strengthened and vice versa, including the most recent bout of Euro weakness being accompanied by the Fed being the more aggressive. Some people have also pointed out that real yield differentials using year-on-year CPI as the deflator, favours a weaker dollar today. The real yield of the US 10-year is lower than that of the German 10-year, but this has only materialised in the last few weeks, and this has been a period during which the dollar has actually bounced. So that's also an unlikely culprit. For some of this year. The euro did seem to be following the actual yield differential for US bonds over German bonds, but that has also broken down in recent days. Therefore what appears to be in play is not the size of the monetary policy, but the sentiment the policy creates. The euro really started to rise versus the dollar last year once the EU had passed its fiscal package. The buying of the ECB has also created a backstop for all eurozone bonds. Yields have been falling everywhere so that even Greek 10-year yields have fallen below yields on 10-year Italian bonds. Europe is probably being rewarded for the apparent removal of default risk in the periphery. Capital gains can still be made on these bonds, and the need to locate capital outside of Europe has been reduced. As a result the more that the ECB does, the more it pushes yields lower, providing capital gains for the underlying bonds, which remain at the very heart of European investing, reducing capital flight. So in this topsy turvy world, Europe is being rewarded for diluting its currency the most because it comes hand in hand with a backstop for European assets.
[00:13:37] And the second question comes from Luke, who asked about the consequences of the dollar and US bond yields on emerging market bonds and in particular, India. The main impact will be through the tightening of financial conditions. A stronger dollar tightens financial conditions, which are currently near their lows. India is in a relatively strong fiscal position, but what also matters is that many investments into all EM regions have been in the form of dollar exposure from foreign investors. If the dollar rallies, then the value of these investments in local terms will fall, encouraging US investors to take profits and repatriate their capital. This relationship is clearest for the performance of EM equities vs. the dollar. When the dollar falls, EM equities outperform and when the dollar rises, they underperform. EM bond markets will often take their lead from US yields, which are the global benchmark. If US yields rise, investors will again reduce their EM exposure to preserve their capital. This is what we saw during the taper tantrum of 2013. Both EM equities and EM bond funds saw significant outflows and price underperformance. India should still be an attractive destination for long term capital. The 10- year government bond offers a 6 percent yield compared to the US at 1.5 percent. Now, obviously, this comes with higher risks, both from economic uncertainty such as inflation and currency risk. But many international investors have been eyeing long term convergence. But in short, EM bonds and Indian bonds are likely to suffer if U.S. yields or the US dollar rally hard from here. At the moment, it looks more likely that if the US dollar rallies, then US bond yields will actually fall. So we should probably keep our eye on the performance of the dollar in the short run. And one of the main things to remember is that these relationships are constantly changing. Relationships that look strong over long time periods can still have short-term periods of extreme divergence, so investors should constantly be checking their own framework for changes. And please keep your questions coming and put them in the comments section and then we'll try and answer them or do our best job at trying to explain them in future episodes.