The equity market has been very quiet so far in 2017. Year-to-date, the S&P 500 has posted a daily decline greater than 1% only once (on March 21), and the realized volatility for S&P 500 has reached the lowest point in the last 50 years.
The backdrop for the low volatility is widely recognized: the U.S. economy is growing a little above trend, a new pro-growth president was elected, inflation is rising but still remains low, the risk for a hard landing in China is lower, Europe and Japan are growing at the fastest pace post-crisis, and most importantly, low inflation allows the Federal Reserve (Fed) to intervene whenever we have some volatility in the market.
With such a favorable environment, volatility selling is a popular strategy—and volatility sellers actually dampen the volatility in the market. Market makers have indicated investors will come in to sell volatilities for every 0.5% “selloff.” Amazingly, a 0.5% decline constitutes as a selloff nowadays!
Selling volatility used to be an activity mainly engaged in by banks’ trading desks and hedge funds. However, with the yield being so low and income needs so high, we are seeing retail investors, mutual funds and pension funds become active sellers of volatility. Again, this is how low yield pushes investors further and further out of the risk curve. Another sign that investors are moving out of the risk curve is the increased popularity of structured notes. Structured notes may offer investors higher income if certain criteria are not met, such as if Apple stocks trade above $100, or if the difference between two-year and 10-year Treasury rates is above 100 basis points (bps), etc. Investors will not earn income if such criteria are triggered. These structured products were popular in Japan because they entered in an extremely low yield environment long before the U.S. Today, these products are becoming increasingly popular among U.S. investors, who are essentially selling volatility to earn higher income when they buy these notes.
Because of this low volatility environment, many commodity trading advisors (CTAs) currently have a record of a long equity position. Leverage was built slowly during quiet times and absorbed violently during volatility.
Another interesting development is the equity sector rotation. This year’s sector performance is very similar to what was seen in 2015. Large capitalization/defensive sectors, including consumer staples, utilities and healthcare, and mega-capitalization/secular growth stocks, such as Facebook, Google, Amazon, Tesla and Netflix, are leading the rally, while small capitalization and cyclical sectors are lagging. With these factors in mind, 2015 is not a bad guide to forecast the equity return for this year.
There is a significant difference in this cycle. In past cycles, when financial asset valuation reached current levels, we could always point to excess at one major part of the economy. In this cycle, however, even though the financial asset valuation is very rich, there is not much excess in major components of the economy. We see excess in auto lending and some in commercial real estate, but nothing systematic. Without excess in the economy, the risk of a recession is low. Without a recession, the risk of a 20% downturn in the market is very low. This is also why selling volatility and buying on dips are so popular now.
The reflation trade that was very popular after the presidential election has faltered in 2017. After the election, the “soft” sentiment-based data jumped, but the “hard” economic activities-based data didn’t improve much. There was hope that hard data would catch up with soft data; however, in the last two weeks, we have seen weak retail sales, employment data and CPI. Gold and treasuries have rallied sharply in recent weeks, which is worth monitoring. We are on a hiking cycle, but rates refuse to move higher, so it remains to be seen what is being signaled.Key Takeaways:
The market is quiet right now but still dangerous. Investors shouldn’t increase leverage to enhance return when volatility is low. Valuation is high for financial assets, but we probably have to wait a little longer for the bargain prices because there is not a lot of excess in the economy.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
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