THE S&P 500 has not had a 5 per cent fall since before last year’s US presidential elections, soaring by more than a third since those lows.
In Australia, the S&P/ASX200 is up by a quarter over the same time frame.
Conventional wisdom says the longer markets rise, the more risk of correction must be building in the system.
But this time around the conventional wisdom looks wanting, according to Tom Ciszewski, a volatility analyst with Pendal’s Bonds, Income and Defensive Strategies team.
Risk measures and positioning can often be a contrarian indicator says Ciszewski.
When investors are hedging themselves it often can be supportive of further bullish performance. On the other hand low hedging and bearish positioning can be a sign of complacency and a relative market top.
“The way derivative risk and implied volatility is priced right now in equities globally, it’s actually pricing in for a pretty benign environment,” he says.
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Ciszewski says investors should keep a close watch on how big institutions position themselves in derivatives markets as they protect their portfolios against the risk downturn.
Perhaps paradoxically, Ciszewski’s confidence is founded on the fact that institutions have been buying downside protection as the market rises.
This is because in the past over-confidence and complacency among institutional investors is an indicator that markets may be close to topping out.
“You’re always looking for when and how things will blow up. What is the next downturn going to be and how will we make money during it?” says Ciszewski.
“But right now, there’s very little complacency. The institutions are giving up a little upside to buy more downside,” he says.
One way to measure institutional sentiment is the ratio of put and call options being traded.
A high put/call ratio indicates more people are buying puts than are buying calls. It’s an indicator that investors are protecting themselves against potential market falls.
The SPX put/call ratio, which measures options on the S&P500, has risen over the past year to above two. That indicates twice as many put options as call options are trading on some days.
Ciszewski says institutions may be buying downside protection simply because they have had a strong year of gains and feel they can afford to protect themselves, or it could be they see genuine risk on the horizon.
Corroborating the high level of put buying and lack of complacency by institutional investors is the current level of SPX Index option skew. The implied volatility of downside strike puts versus upside strike calls is at multi-year highs.
“Either way, it has this kind of circular effect and allows the market to continue to grind higher.”
So, what will change the benign outlook? And what risks should investors be keeping an eye out for?
Ciszewski says inflation is the biggest potential threat, saying that if markets are wrong and the inflation showing up now around the world is not transitory, that could end the equities rally.
The other risk is if the COVID pandemic manages to outmanoeuvre vaccines and triggers new lockdowns and border closures.
Right now, neither scenario looks likely, he says.
Institutional investors are confident inflation is a temporary effect of reopening.
And markets are looking through the COVID pandemic to a time when life returns to normal.
“There’s more American cases of COVID this Labor Day than there were last Labor Day,” says Ciszewski.
“It doesn’t mean they’re going to lock down. We all have to be careful about merely reading the headlines.”
Thomas Ciszewski manages Pendal’s volatility fund, implements defensive derivative structures and develops multi-asset class strategies. He has 24 years of experience in managing derivative portfolios and producing positive uncorrelated returns for investors.
Pendal’s BIDS boutique is one of the most experienced and well-regarded fixed income teams in Australia. In 2020 the team won the Australian Fixed Interest category in the Zenith awards.
With the goal of building the most defensive line of funds in Australia, the team oversees A$22 billion invested across income, composite, pure alpha, global and Australian government strategies.
Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.
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