After another strong jobs report this past Friday, the S&P 500 Index is again testing its all-time high, up over 25% for 2019. However, according to a recent poll, many Americans are either unaware of or have not participated in the bull market this year. The dot-com bubble in the early 2000s and the global financial crisis last decade may have scarred older generations who now shy away from stocks as an asset class. Even in the last five years, owning stocks has not come without its share of headaches, with violent sell offs in 2015 and 2016 and a 20% meltdown to close out 2018. But as we approach the end of the decade, the S&P 500 Index is on track to post an annualized total return in excess of 13% for the decade.
This week’s chart revisits the S&P 500 Index options markets and normalized skew, which measures the price of put options relative to call options. Put options increase in value when the S&P 500 Index declines, whereas call options rise in value when the S&P 500 Index increases. Since the beginning of the year, normalized skew has increased, indicating that the cost of downside protection (i.e., puts) has risen relative to upside protection (i.e., calls). At first glance, this trend may be at odds with how strongly the stock market has performed this year.
Skew was also high (i.e., steep) back in 2017 when the S&P 500 Index returned 22%, including dividends. Stock market performance in 2017 was driven by strong global growth and a benign policy environment. Indicators suggested that investors were increasing their allocation to equities, which reduced the need for upside protection and increased demand for puts to hedge a larger asset base invested in equities.
The rally in 2019 has been greeted with more skepticism. Overall levels of equity investment aren’t as high as they were two years ago and a number of ongoing and upcoming events have kept the perceived risk of owning stocks high. The trade conflict with China and other partners, the upcoming Democratic primaries and the 2020 presidential election all pose risks to this year’s record run. As a result, investors have not been chasing the upside and are instead buying puts to hedge their gains for the year and protect against adverse outcomes related to these events.
Investors remain fearful of escalation in the trade conflict and the risk presented by next year’s election. Despite these fears, the U.S. economy remains strong, driven by the U.S. consumer and solid employment. Furthermore, the Federal Open Market Committee has communicated that the bar for future rate hikes is high, alleviating one of the biggest risks to risk assets coming into the new year. If the U.S. and China reach a “Phase One” trade deal or a market-friendly candidate emerges as the Democratic presidential nominee, stocks could continue their march higher. Funding upside protection by selling puts right now is an attractive way to set up for this more optimistic scenario.
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.
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