To all this existing dysfunction, add the fact that we find ourselves in a presidential election year, and a race to the finish that will likely be more rancorous than any in perhaps living memory, and the prospect for increased market volatility only grows.
How Investors Are Responding And How Should They Respond?
The retail market appears to have lined up on the single stock call buying side, while institutional traders, such as hedge funds and banks, appear to be large buyers of index puts to hedge exposures. Interestingly from a global investing perspective, this is predominantly happening in the U.S. and not foreign markets, which is very reminiscent of 1999.
Investors of all types have been flocking to gold and buying puts to hedge against inflation and downside volatility, respectively. Those moves make sense but there is a third leg to the stool that also needs to be included to allow for exposure to more potential upside amidst all this downside protection: equities. Here though, selectivity is key, and in our view global equities currently look like they have a lot more room to run in terms of valuation, especially compared to the S&P, which has more and more come to be dominated by a handful of big-name (and richly valued) tech companies.
Investors would also do well to consider their bond exposures amidst the current conditions to make sure their expectations around risks and rewards still hold true. The idea that there is a negative correlation between stocks and bonds is actually not true (make that a third “elemental fact” I’m taking issue with).
It had been a bull market in bonds for decades, but with rates at zero and a Fed that is explicitly promising to keep them there for the foreseeable future, that bull run appears to be over. In fact, I would argue that investors looking for decent rates of return and a modicum of safety in their portfolios should consider moving out of bonds entirely. Gold, put-focused strategies and global equities, used in combination, appear much better positioned to provide investors with not only downside protection but exposure to parts of the market that may be poised to generate more upside.
So, while some of the “elemental facts” that have driven key thinking around portfolio construction for the past several years are no holding true, there is one thing we do know: things tend to get worse before they get better. We saw this in the last major market crisis and the crises that came before.
But no one sends up a flare when a crisis has run its course, and the current environment may yet drag on, so for those financial advisors and investors who are considering fundamental portfolio changes, looking at the lapses in these elemental facts may be a good place to start.
Josh Silva is a partner and portfolio manager with Harvest Volatility Management.