What do seagulls have to do with financial markets?

The equity markets have recently returned to somewhat calmer waters. Volatility has decreased significantly, and the main stock indices have recouped more than half of their corona-crash losses. Their divergence from economic reality, though, could hardly be more striking. Economic indicators are hitting one all-time low after another, and in the reporting season currently underway, the majority of CEOs are shying away from issuing an outlook for the rest of the year. At the moment, central-bank monetary policy accommodation is the only support (aside from hopes for better times) undergirding the equity market. In our opinion, however, investors shouldn’t rely on the “Fed put” alone. Given the considerable potential for share-price setbacks, we think it makes sense to employ options-based hedging strategies. A “seagull spread” strategy particularly presents a good cost-benefit tradeoff.

 

Impressive (bear market) rally…

Equity markets around the world have staged an impressive rally in recent weeks. The S&P 500 index in the USA and the SMI in Switzerland have climbed 34% and 28%, respectively, since hitting their late-March lows and have thus recouped around two-thirds of their corona-crash losses. Optimists lately have thus already begun to call the next bull market. But using a simple 20% rule to define bull and bear markets has always been a pastime for statistics aficionados. Smack in the middle of the coronavirus pandemic setting, this definition approach does not do justice to the complexity of the macroeconomic developments currently unfolding. Viewed objectively, all one can say is that the snappy rally over the past weeks bears a degree of symmetry with the preceding record-fast crash.

 

Major obstacles in the way
Rangebound trend at best

S&P 500 index with moving averages

Source: Bloomberg, Kaiser Partner Privatbank

 

…stands in contradiction to the hard data

But there is no reasonable symmetry at all between the stock-market rally and economic reality, at least not at first glance. Recent days have delivered a barrage of grim economic news from every direction. US GDP, for example, contracted 4.8% in the first quarter, plunging past even the worst of expectations. GDP growth data from Europe (–3.4%) were also deep in the red. In both instances, though, this was merely a foretaste of what awaits us in the weeks ahead. The free-falling business and consumer sentiment indicators give reason to expect far worse numbers for the second quarter. What the second half of the year holds in store remains extremely uncertain at the moment and depends greatly on how quickly national economies around the world can regain their stride after safety restrictions to combat the pandemic are gradually lifted. Initial indications from China, which is around four to six weeks ahead of the West in the pandemic’s evolution, are very disillusioning in this regard: it looks as though a return to normalcy will take far longer than originally hoped.

 

Historic plunge
Lower than during the financial crisis

Global purchasing managers’ indices

Source: Bloomberg, Kaiser Partner Privatbank

 

The corporate reporting season currently underway is also reflecting the immense uncertainty about what awaits us after summer. The vast majority of CEOs are refraining from issuing any guidance at all for the rest of the year. Analysts’ corporate earnings estimates for 2020 accordingly amount to guesswork. The only thing really certain is that earnings forecasts will be lowered even further in all likelihood. Based on the figures reported thus far, first-quarter net earnings for the companies in the S&P 500 index fell 10% year-on-year. But, as is the case with economic activity, corporate earnings don’t look set to hit bottom until the second quarter.

 

Corporate earnings tumbling downhill
Further downward revisions required

Evolution of earnings estimates for the S&P 500 index

Source: Bloomberg, Kaiser Partner Privatbank

 

The coronavirus crisis will leave scars

Afterwards, however, there’s little likelihood that corporate profits will quickly climb back to their former heights. There are always exceptions to the rule, though, particularly in the technology sector, where Microsoft, for example, has shown itself to be practically immune to the coronavirus. But even the top-notch companies of the past several years are exhibiting skid marks in their business performance. Apple’s iPhone business, for instance, is bound to be appreciably harmed in the months ahead. Amazon, meanwhile, is registering higher sales as a result of the pandemic, but is also incurring much higher costs.

The public health crisis is exerting an even far more detrimental impact on other sectors. The aviation industry is likely to survive only by grace of government support, but nevertheless faces a sharp reduction in business volume in the years ahead. In the retailing sector, meanwhile, the crisis is speeding up the structural transformation by several years – whoever neglected online business thus far is likely to fall by the wayside. And lastly, the banking sector faces the threat of a flood of loan defaults. The challenging environment for numerous industries has dimmed the prospects for new earnings records at the index level. On the other hand, market valuations as measured by classic metrics like the price-to-earnings ratio are currently at the upper end of their historical range.

 

Stocks are not a bargain
High Prices + Low Earnings = Expensive

Forward price-to-earnings ratio for the S&P 500 index

Source: Bloomberg, Kaiser Partner Privatbank

 

Is the “Fed put” sufficient?

Weak economic activity, lower earnings, pricey valuations – taken altogether, this means that stocks are facing a formidable fundamental headwind. On top of that, a major share-price driver in recent years will soon largely disappear because, as a precaution, companies by the dozens are not only cutting their dividends, but are also largely forgoing stock buybacks, which were indulged in to excess in the past, to protect their liquidity. At the moment, the equity market is getting support almost solely from central banks. That support, though, is humongous. Bond-buying by the US Federal Reserve, for instance, looks set to roughly double the amount of assets on its balance sheet this year. At the end of April, Fed Chairman Jerome Powell reiterated that the central bank’s firepower is limitless and that it would continue with its ultra-accommodative monetary policy until inflation rises toward 2% and unemployment drops back toward the pre-crisis level. Calculated realistically, the timeframe needed for that to happen stretches more likely over years rather than quarters or months.

The swift reaction to the public health crisis by central bankers significantly calmed the financial markets as volatility diminished and credit spreads tightened. However, some stock indices have already climbed back to lofty altitudes that hardly appear justified by the fundamentals. Moreover, major obstacles are now surfacing on the top side of price charts. The S&P 500 index, for example, is facing a cluster of resistance levels lined up between the 3,000- and 3,100-point marks. Even though the “Fed put” is more firmly in place than ever and the markets may still have some upside room to run in the near term, we see substantial setback potential for stocks in the weeks ahead.

 

A “seagull spread” is a sensible way to hedge the equity part of an investor portfolio for the months ahead.

 

 

A second safety net makes sense

Investors should therefore think about whether they might want to add a second safeguard to their portfolios. Such a hedge can be implemented, for example, by using options. Since our market expectations foresee residual mild upside potential in the near term but a substantial risk of a correction in the medium term, an option strategy combining a long put spread with a short call lends itself as a good solution. How do long put spreads and short calls work?

Long put spread: For the put spread, one typically purchases a put option with a strike price slightly below the current price of the underlying asset (an index or a stock), 5% lower for example. At the same time, one sells a put option with a strike price far below the current price of the same underlying (far out-of-the-money), 20% lower for instance. Selling that put option makes the insurance premium for protection against falling prices a bit cheaper, but at the same time limits the protection. In the end, the investor with the put spread is protected against falling prices between the two strike levels, i.e. between –5% and –20% in our example above.

Short call: Under this strategy, one sells a call option with a strike price above the current price of the underlying asset (10% higher for example) and collects a premium upfront. If the price of the underlying exceeds the strike price when the option expires, the seller of the call option must deliver the underlying to the buyer either physically or indirectly through a cash settlement. The profit potential on a short call is thus limited to the upfront premium collected.

By combining a long put spread with a short call, one can further lower the cost of insurance against falling prices. At the same time, though, one incurs potential opportunity costs because this strategy limits participation in rising prices. When looking at the payoff diagram for this combined option strategy, with a little imagination one can make out two “wings”, which is why this strategy is also known as a “seagull spread” in specialist jargon. A “seagull spread” is a sensible way to hedge the equity part of an investor portfolio for the months ahead. In our estimation, the cost of the insurance stands in sound relation to its benefits at the moment.

 

The “seagull spread”
Comparatively cheap insurance

Payoff diagram for “seagull spread” option strategy

Source: Bloomberg, Kaiser Partner Privatbank

Oliver Hackel, CFA Macro and Investment Strategy, Behavioral Finance and Technical Analysis

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