Volatile expectations call for market-risk mitigation
'Too much of a good thing' fuels investor nervousnessApril 12th, 2018
Equities are continuing their recent selloff and prices are showing more volatility. The S&P 500 is dropping close to its February lows—its first major pullback since early 2016.
The U.S. economy currently is expanding at an annual rate of about 2.5 percent. S&P 500 earnings grew by double digits last year, and revenue growth has also been strong. Unemployment stands at 4.1 percent, a 17-year low, and inflation is expected to remain between 2 and 3 percent. Economic growth around the globe is also flourishing.
So, with economies expanding all over the world, and interest rates, inflation and unemployment remaining low, why are investors nervous?
In part, they're nervous about too much of a good thing. The latest growth figures have been solid, but they have shown a jump in hourly earnings, fueling concerns about rising inflation. Consequently, bond yields have risen, which could lead to increased borrowing costs and foster aggressive policy tightening.
The Federal Reserve already has raised rates 25 basis points this year, and the new Fed chair has spoken with a more hawkish tone. The market is expecting two further rate hikes this year—possibly three. Investors are therefore concerned that these increases might choke growth.
In addition, in the last month, President Trump and China have imposed dueling tariffs against one another, raising fears of protectionism.
Finally, price-earnings ratios are still well above historic norms. Elevated P/E ratios may not be a good indicator of the direction of the market in the short term, but awareness of their overall high level increases anxiety, and fear is a motivator that can lead to quick action.
As a result, we expect volatility to remain elevated. Pullbacks are not uncommon, and corrections are a normal part of a well-functioning market. Around the globe, stock declines of 10 percent or more have occurred in two-thirds of the years since 1979. However, 2017 was one of the least volatile years on record. As a result of this stability, investors have become complacent, which leaves the market vulnerable to volatility spikes.
So how can investors hedge their portfolios against these volatility spikes? If you’re having trouble sleeping at night because of the volatility, you may want to reconsider your asset allocation and rethink your long-term plan. Jumping in and out of the market based on attempts to predict where it is going is never a good idea. We know stocks will go up and down, but we don’t know when or how far.
Advisers will always tell you to diversify your portfolio, but diversification is about eliminating firm-specific risk, not market risk. Market risk is the risk that will cause even your best stocks to lose value when the market declines. No matter how well you diversify, you will not be able to eliminate market risk.
However, you can take steps to reduce market risk in your portfolio. Following are four ways to hedge your portfolio. First, a word of caution. These hedging strategies range from simple to more complex. Not all the strategies discussed will be available or appropriate for all readers. If you don't have experience in applying these strategies, you should work with a trusted financial professional, whether that's your broker, financial adviser, wealth manager, or financial relationship manager.
High-quality bonds: High-quality bonds can be a good hedge, as bond prices generally go up during times of stress. However, considering that interest rates are rising, you will want bonds with short maturities. Bond prices have an inverse relationship with interest rates—meaning that if the Federal Reserve continues to raise rates, bond prices may fall in accordance.
Alternative strategies: Strategies that have a low or negative correlation to the stock market, such as managed futures and global macro strategies, can hedge market risk. When the market goes down, these alternative strategies should cushion the blow.
Options: The simplest option strategy to provide downside protection to your portfolio is to buy put options. A put option gives the buyer the option to sell a security at a predetermined price before the option expires. Options can mature in days, weeks, months or even years. Put options can be purchased on a number of securities, including stocks and the overall market, such as the S&P 500. So, for example, if the buyer of a put option purchases an option to sell the S&P 500 and the market declines before the option expires, the buyer may profit if the market declines by enough to offset the cost of the option. There are, of course, many other complex option strategies to reduce risk and costs, which are beyond the scope of this article.
Instead of creating option strategies directly, investors can also buy exchange-traded funds that use option strategies to hedge market risk. One caveat: option strategies can be complex and should not be undertaken by novice investors. The risks can be difficult to calculate, even for sophisticated or institutional investors. Just recently, two ETFs that were heavily involved in options failed due to the managers’ lack of understanding of the risks.
Dynamic hedging: Current research is enabling investors to take advantage of dynamic hedging to reduce portfolio risk when market risk is high. Firms are beginning to develop strategies that use signals in the market, such as the volatility index, to help reduce risk when appropriate.
Research has shown that the more volatile asset classes, such as commodities and small-cap international stocks, do poorly when market stress is high. This reaction makes perfect economic sense, and responding to these signals should not be confused with the common mistake of letting emotion and hindsight bias determine when you should invest.
When risk is high, riskier assets should respond more negatively. Therefore, reducing exposure to these asset classes during periods of stress helps lessen the risk. Additionally, increasing the share of assets that do well during volatile times can actually add value. These assets include high-quality bonds and managed futures.
As we all know, markets go up, but they also come down. To paraphrase Ben Graham, one of the pioneers in stock investing, managing investments is about managing risks, not returns. During good times, you should make sure you have proper risk management strategies in place for your portfolio. This will keep you from trying to time the market or letting your emotions drive your financial decisions and will enhance long-term growth.
Richard Cloutier is vice president and chief investment strategist for Washington Trust Bank’s Wealth Management & Advisory Services in Spokane.