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Is it the calm before the storm?
Peter Garnry
Chief Investment Strategist
Summary: Downside volatility in US equities has hit the lowest levels since 2018 and with potential headwinds for the economy arriving investors should think about ways to lower their equity portfolio risk. This can be done several ways ranging from options, futures, to that of simply adding bonds to the equity portfolio as bonds will often attract safe haven flows if volatility increases in equities.
Key points in this equity note
- Downside volatility in S&P 500 has reached levels not seen since 2018. Historically such low levels of volatility are often succeeded by a violent release of volatility triggered by an unpredictable event.
- With obvious cracks emerging in the economy from higher interest rates and the US fiscal impulse turning from tailwind to headwind it might be a good time to consider lowering the risk in your equity portfolio by either hedging or adding bonds to the portfolio.
Lowest downside volatility in US equities since 2018
The 128-day downside volatility, measuring the standard deviation of negative returns, in the S&P 500 Index has reached its lowest levels since 2018, in fact the period before the market began pricing a potential Fed policy mistake, consistent with recent market observations of low implied equity volatility in US equity options and the return of US technology IPOs (Arm and Instacart). Whenever the equity market reaches these low downside volatility levels it means energy is getting compressed and trends/momentum are amplified to unsustainable levels. Such a period is often followed by a violent release of volatility (energy) triggered by a breakdown in the narratives and trend that were in place as volatility got compressed.
When equity market valuations go new stretched levels, and we see dangerously inflated IPOs such as Arm and Instacart, the US fiscal impulse going from tailwind to headwind, combined with low realized volatility, then it is time for investors to ask whether now is a good starting point for thinking about downside risks.
Mitigating downside risks in an equity portfolio can be done in several ways. One way is to buy put options on benchmark equity indices (expiry in 3-6 months from now) which pays off if equity indices fall below the strike price less the premium paid for protection, short positions in equity futures or CFD (also called delta one hedging because the hedging kicks in immediately), or even more simple adding bonds to the portfolio as any hiccup in equity markets will trigger safe haven flows into bonds.