Is this the “Mike Tyson moment” for markets?

Bid-ask spreads on the iShares 7-10 Year Treasury Bond ETF have also steadily been rising for years. We are not seeing panic mode like during the policy mistake around the Christmas holiday of 2018 and the chaotic days of the Covid pandemic, but the steadily rising spreads suggest perceived risks by market makers in the Treasury market are going up. We could be on a path to a point where something really breaks.

S&P 500 futures are down 8% from their highs back in July but have recovered somewhat in today’s trading session as US bond yields are coming down a bit from their intraday highs. Equities are naturally getting impacted with higher interest rates as every move higher from here leads to a larger and larger impact on equity valuations through the cost of capital delta is higher than the delta on growth on cash flows.

If take a look at volatility the VIX Index itself has not yet switched to panic mode. The VIX futures forward curve has flattened a lot recently after one of the longest periods of being in contango (upward sloping). If the VIX futures curve moves a bit into backwardation, as it did this morning, it is not critical. It becomes critical if the VIX forward curve inverts a lot because it signals panic hedging in the front part of the curve. The fact that the VIX has not switched to panic mode yet suggests that there is still downside risks to markets as these bigger moves in markets never stop until something breaks and the VIX forward curve shows that nothing has broken yet.

Are the options for the investor?

The first thing to acknowledge is that there is not one option that fits all investors. We all have different time horizons, return objectives, saving profiles and risk attitudes. The different options available to investors can be categorized into two groups: simple and advanced strategies. The more advanced hedging strategies involve options and futures which are covered in Steen’s macro note and in some of the various notes we have written before on hedging (see links in the next section).

For many investors with a longer time horizon and a less active approach to the market some of the key things to consider are the following:

• Cash. There are two ways to think about cash exposure. 1) sell existing positions to raise cash exposure, or 2) stop investing more and let your excess savings roll into cash and wait patiently before investing more in the market. Investors should generally avoid going all cash as it increases your timing risk – if you got lucky on the way out, you have to be equally lucky getting in again. I have personally the scars to prove that going all cash is a bad idea. Going to 50% cash is still a very defensive position in a historical context and the good thing about being invested is that it is psychologically much easier to increase market risk again.
  
  
• Diversification. Many retail investors run concentrated portfolios so when market risks go up it is important to reduce concentration risk. One option is to reduce your top holdings and move the exposure to an ETF tracking the global equity market – this makes sense if you want to be invested long-term and wants to increase diversification. Concentration risks can come in many forms. Some have 8 stocks, but they are all technology stocks. In this case you think you have diversification but in reality you are exposed to a small set of risks. So investors should make sure they are not too exposed to a single sector.
  
  
• Defensive vs cyclical. As we wrote back in August stagflation risks are rising and so are the risks in cyclical sectors. Historically a stagflation like scenario is bad for technology, financials and real estate. Defensive sectors such as utilities, energy, consumer staples, and health care typically do much better in a downturn so it is important for investors to avoid being to exposed to cyclical sectors and especially technology stocks.
  
  
• Avoid mega caps. A big theme this year has been AI which has inflated US mega cap stocks to a degree in which there is now a significant performance difference between an equal-weighted US equity index and a market cap weighted index. This reflects outperformance among these mega caps and that could quickly change if sentiment changes on technology.

What have we written in the past on managing risk?

Below we have listed previous notes we have written on hedging market risk which can be done in many different ways. Above we explained some simple things and the more advanced strategies are presented below.

Hedging – a guide to reducing portfolio risk by Peter Siks. Explains hedging using futures.

Investing with Options: Hedging your Portfolio by Koen Hoorelbeke. Explains out-of-the-money put options and VIX call options.

What are the different strategies to hedge your portfolio? By Peter Garnry. Explains hedging using cash, diversification, shorting using CFDs and futures, long put options, and long volatility using VIX futures.

How to use protective put and covered call options by Gary Delany. Explains how to use two simple options strategies change the risk profile of a position.

Recession Watch: Is gold really a safe hedge? By Ole Hansen. Explains why gold has often been a good hedge during recessions.