The start of 2019 could not have come fast enough for equities. U.S stocks ended 2018 with one of the roughest quarters since the financial crisis, and after peaking in late September, the S&P 500 Index sold off nearly 20% by market close on Christmas Eve. By the start of December, other markets were contributing to the risk-off atmosphere. Gold – traditionally a safe-haven asset – rallied 5% during the month; HYG - the junk-bond ETF, -was down almost 5% at one point; and the yield on 10-year Treasury bonds fell 0.30%. All signs in 4Q18 pointed to a broad-based selloff in risk assets going through the market. So it may be surprising that the cost of buying downside protection for equities decreased relative to the cost of buying protection for equities rallying.
In this week’s chart, the orange line shows normalized skew on 3-month S&P 500 Index options. Normalized skew measures the price of put options relative to call options (put options increase in value when the S&P declines; call options increase in value when the S&P rises). While this wasn’t the first time equities had a significant decline in the past several years, this period saw normalized skew fall to multi-year lows. What was different this time, and what are option markets telling us?
First, we’ll look at a period when normalized skew was high (i.e., steepened). A good period to look at is the tremendous equities run during 2017 and the first month of 2018. As equities rallied in the strong economic environment, investors piled more and more money into the stock market. One sign of the strong demand to own equities was the rising financing cost for institutional investors to own equity exposure via a total return swap (TRS), which gives the buyer exposure to equities without having to spend the cash to purchase the stocks outright. When investor allocations to equities are high, the demand to own downside protection (i.e., puts) increases. Concurrently, investor demand for call options declines since they are already long equities from owning stocks or buying exposure through TRS.
The end of 2018 saw investors de-risking and reducing their equity exposure. A sign of this was the declining cost of buying equity exposure through TRS – displayed as the green line on today’s chart. As equity allocations decrease, there is less need to protect equity exposure with puts. However, the demand for call options can increase from investors who have reduced their equity exposure but still need to pursue performance in the event of an equities rally.
Key Takeaway
The selloff that ended 2018 feels similar to the selloff that started 2016. In both cases, the stock market price-to-earnings ratio forecasted declining corporate earnings as a result of several negative developments, including: a slowdown in the Chinese economy, monetary tightening by the Fed and stress on high-yield credit from falling oil prices. Heading into the start of earnings season, the bar for companies has been set low and equity positioning among investors feels light. These factors could contribute to near-term strength in the stock market even if earnings are disappointing, but not below the already low expectations.
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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