Investors ignoring market signals
The economic ingredients that precipitate extreme volatility are in place in global markets, and investors should take steps to protect their portfolios.
Despite periods of episodic volatility over the past few years, it has actually been one of the least volatile times, for realised volatility, compared with time frames over the past 50 years.
But despite there now being a number of market indicators that suggest global assets are overpriced – price earnings ratios at high levels, developed economies facing an economic slowdown, and ongoing trade war concerns – investors appear complacent about protecting their portfolios from a downturn.
Domestically the tide has turned on interest rate expectations, with markets now beginning to price in an interest rate cut, after years of anticipating the next move would be up. If this is the case, it will have a significant impact on the Australian dollar.
As well, property markets in Australia appear to have peaked, while globally Canada and Spain are also experiencing a similar peak in their property markets.
Over in the Eurozone the market is facing Brexit and its implications, while simultaneously struggling with the best way to unwind quantitative easing. The US has already started down the QE easing path and the results remain to be seen – particularly in light of the additional trade and political discord in that market.
Add in the difficulties being experienced in China, from the trade dispute it is embroiled in focused on IP rights and theft of technology – to its economy which has been pump primed to within an inch of its life – and questions remain about how the trade war cards will fall and how much more liquidity it can realistically provide.
In short, there are a lot of indicators in markets that should have investors concerned.
But it appears they are not.
Take the options market as an example. There is a stark paradox to these economic threats that is being expressed in the options market. Using the put/call ratio metric as an example – which measures how many puts are in the market versus calls - we are seeing one of the lowest put/call ratios since we have been recording data.
Essentially, this means there are not a lot of people buying put options. Normally the put/call ratio is heavily biased towards puts because investors tend to be long equities, and they use put options as an insurance policy of sorts to protect from downside risk.
That the put/call ratio is sitting near its lowest levels since before the global financial crisis means that investors aren’t placing a premium on protecting their long only exposures.
Investor expectation, despite myriad economic indicators to the contrary, is that markets will not fall. And history shows it is usually precisely at the time when everyone is bullish, that markets do fall. This optimistic investor sentiment is a concern.
Differing signals from market indicators add to mixed sentiment. For instance, the realised volatility of the S&P500 in recent months has been high - in the 90 per cent quantile - and yet expected volatility as measured by the CBOE Volatility Index (the VIX) is very low – hovering around the 15 mark.
Chart 1: S&P 500 options put/call ration
The VIX is considered the benchmark barometer of market volatility and investor sentiment. It is a measure of expected volatility on the S&P500 Index (SPX) over the next 30 days. A high VIX reading indicates that investors expect that the market will move sharply. The 20-year average of the VIX registers at just shy of 20, although it has moved as low as 10 and as high as 85.
That these two measures of volatility are at odds sends another mixed signal to the markets.
One of the reasons why investors may be so complacent is that, despite periods of episodic volatility, 2018 was in fact the least volatile market of the past 100 years.
But this complacency is unjustifiable given everything else that is going on.
Stocks are highly priced relative to various measures - including the Cape Shiller price earnings (PE) ratio. Often seen as a more useful indicator than traditional PE ratios, this adjusts past company earnings by inflation to present a snapshot of stock market affordability at a given point in time.
In this environment, it is somewhat surprising that the put/call ratio is so low, and that the volatility levels as expressed by the VIX are also low. As a result now is, in fact, a good time for investors to be looking to put protective strategies in place.
One way to help protect against sharp market downturns, is to invest in volatility; while you cannot invest directly in volatility, the creation of the VIX index and the highly liquid derivatives based off it, means volatility is an investable asset class. The most common way for investors to simply gain exposure to volatility is to buy Funds that hold VIX derivatives that profit when volatility spikes.
Volatility is an asset class that is causally negatively correlated to equities; it is inversely related to equity index prices, especially when there are large moves. Typically, the more equities fall, the faster volatility (i.e. the VIX) rises. It has what’s called a ‘convex’ payoff profile – the more the SPX falls, the harder and faster the VIX tends to rise.
Chart 2: VVIX is at near 18-month lows
Volatility has negative correlation to equities – and most other asset classes – so can be used to enhance returns, manage risk and potentially provide an additional source of alpha to an investment portfolio.
The opportunities to do this in the Australian market are limited without professional options trading knowledge. Many superannuation funds have adopted the solution of an options-based volatility overlay, and in the coming months there will be an ETF option which is expected to be particularly attractive for self-managed superannuation fund investors. However, for now, purchasing put options directly are the best solution.
Investors should err on the side of caution. When you look at the fact that the put/call ratio is so low, it means that the price of this insurance is also low.
The confluence of all these factors – the metrics for options as well as where we are economically - means 2019 should be a good time for owning some sort of protection strategy.
There are vulnerabilities in the market everywhere you look, and options prices are not exorbitant. The sensible investor would start to strap them on.
Simon Ho is chief executive of Triple3 Partners.