Suppose that you’ve been given $1,000,000 of cash in an IRA to manage. Your task is to invest it so as to generate the best possible risk-adjusted return over the next 12 months. You don’t have to invest it immediately–you can hold it and wait for a better entry point. And you don’t have to commit to what you buy–you can trade. However, you can only have the money invested in one asset class at a time–all of it. Diversification across asset classes is not allowed.
(Note: obviously, in real life, you would never put an entire portfolio in one asset class–but I want to use the example to zero in on the most attractive asset class in the market right now, which we would ideally be comfortable putting all of our eggs in.)
To be clear, your client is a high-earning corporate executive in her late 40s, who doesn’t plan to draw from the money for at least another decade. But 12 months is the timeframe on which she’s going to evaluate your performance. Importantly, her assessment isn’t only going to be about the return that you earn for her, but also about the psychological stress that you put her through with your decisions. She can handle paper losses, but only if she can be reasonably sure that they will eventually be recovered. She will know if you’re winging it, investing based on poorly-researched ideas that you don’t have a basis for being confident in. So you need to find a solution that’s genuinely compelling, with the uncertainties honestly considered and the downside risks appropriately addressed, that she can feel comfortable with.
What asset class would you choose? Would you buy now, or would you wait? In what follows, I’m going to carefully weigh the options. I’m then going to propose a solution–what I consider to be the world’s best investment for the next 12 months.
The Fixed Income Space
The table below shows the relevant portions of the current fixed income menu. As you can see, the meal comes light on yield, and heavy on duration risk:
To eliminate the possibility of a loss over the time horizon, you could invest the money in a 1 year treasury yielding 36 bps. But what would the point be? The income earned would amount to a rounding error that wouldn’t even cover your fees. If short rates were to back up more quickly than expected, and you wanted to sell, you could lose more than your upside, even after factoring in the income.
To improve the return, you could invest in longer-dated treasuries or investment-grade corporate bonds. But it’s difficult to make a compelling case for those choices right now, given the low returns that they’re priced to offer. You may be cautious on the global economy, but you can’t dismiss the possibility that the U.S. expansion will pick up steam over the next 12 months, led by continued employment strength and the release of pent-up demand in the housing market. The current complacency in fixed income, characterized by a growing confidence that inflation is dead and that long-term interest rates will stay anchored at low levels, regardless of what the Fed does, could come apart. If that were to happen, treasuries and investment-grade corporates of all maturities would produce negative returns–with the long-end inflicting substantial losses (see the last column, the expected loss on a +100 bps change in rates). Does the potential return that you might earn in a neutral or bearish economic scenario–say, a 2% coupon plus a small gain from roll and possibly from falling rates–adequately compensate for that risk? No.
To further boost the return, you could take on additional credit risk, venturing into the high-yield corporate bond space. The yields in that space are attractive, but the credit losses are non-trivial. Default rates have been low over the present cycle, but if they revert to historical norms (a reasonable assumption, given the present trend), the returns will have been no more attractive than the minimal returns on offer in treasuries.
Yields on speculative-grade corporate debt have been pushed to record lows in the current cycle, even as underwriting standards have deteriorated. They’ve since risen in response to distress in the energy sector, but they haven’t risen by all that much. And the rise has been entirely justified, given the increased likelihood of energy-related defaults. If those defaults play out in force, the impact will be felt not only in the energy sector, but across the entire credit market, as conditions tighten.
The current credit cycle is growing increasingly mature. We need to be thinking about it in terms of the losses that we might incur when it turns. Thinking about corporate high-yield in that way, the space is not attractive right now. A better opportunity, it seems, would be to invest in credit risk tied to the U.S. household sector, the lone bright spot of the global economy. Composite U.S. consumer default rates, which include defaults on first and second mortgages, are at their lowest levels in over 10 years:
What makes the U.S. household sector especially attractive is that it hasn’t developed any excesses that would be likely to produce a deterioration in credit conditions going forward. The last several years have been a process of clearing out the excesses of the prior decade. What has emerged is an increasingly healthy market, with substantial pent-up demand to act as a tailwind.
In 2005 and 2006, default rates were low, but the strength was an illusion brought about by the bubble in the prices of homes, the assets backing the mortgages. When the bubble finally burst, the credit support of the inflated collateral was removed, and default rates jumped. Right now, there’s no bubble in the housing market. Homes across the country are fairly priced and have room for further appreciation. The observed credit strength is therefore likely to be significantly more durable and reliable.
Unfortunately, right now, it’s hard to translate U.S. household strength into attractive fixed income investment opportunities. Agency residential mortgage backed securities (RMBS) do not offer the desired credit risk exposure, and are not priced any more attractively than treasuries. Non-agency RMBS do offer the desired credit risk exposure, and probably represent the most attractive available credit opportunity. But the securities have had a huge run over the past few years, and are no longer cheap.
If the credit cycle soon turns–as it did the last time default rates were this low–non-agency RMBS are unlikely to perform well. In fact, the simple fear of a coming turn in the credit cycle could be enough to meaningfully attenuate the near-term returns, even if that fear were to be misguided.
One enticing possibility would be to invest in the mortgage REIT (m-REIT) space, which has been absolutely demolished over the past year. But it’s hard to invest confidently in that space, given the complicated, black-box natures of the various strategies used, and the extreme levels of leverage implemented. Can the m-REIT space be expected to perform well as the Fed tightens and the yield curve flattens–potentially all the way to inversion? If not, then now may not be a good time to invest in it, at least not on a one year performance horizon.
A more benign possibility would be to invest in leveraged closed-end bond funds. But like mortgage REITs, all that these funds really offer is the opportunity to buy fixed income assets at discounts to their market values. The discounts are currently large, but they come at a cost–the prospect that they might grow larger. If interest rates rise by more than the small amount that the market expects over the next 12 months, or if the credit cycle turns, the discounts probably will grow larger, even as the net asset values drop.
Outside of the U.S., you could invest in dollar-denominated emerging market (EM) debt. But, with the exception of the well-known problem countries–think Venezuela, Argentina, and Ecuador, for example–the yields on that class of debt are not appreciably different from the yields on investment-grade U.S. corporates. The “aggregate” yield of an index or fund of emerging market bonds may appear attractive, but the attractiveness is driven in large part by the contributions from those countries, which carry meaningful default risk, particularly in the current strained, post-EM-credit-bubble environment of a strengthening dollar, falling commodity prices, and weakening global growth.
Instead of dollar-denominated EM debt, you could invest in local currency EM debt. But that would require you to step in front of a powerful uptrend in the dollar, an uptrend that probably has more room to run. Real exchange rates between Emerging Markets and the United States appreciated dramatically from 2003 to 2011. What fundamental or technical reason is there, at present, to believe that the subsequent unwind, which began 4 years ago, is over? None. Emerging markets are the trouble spots of the global economy; the United States is the lone bright spot. There’s presently no sign that the divergence is about to shift–in fact, it appears set to increase further. The operating assumption, then, should be for continued dollar appreciation relative to emerging market currencies. Local yields may be high in real terms, providing a buffer of protection against that appreciation, but as the experience of the last year has demonstrated, currency moves can quickly and easily wipe yields out, leaving dollar-based investors with significant losses.
Mortgage REITs and emerging market debt represent areas where comfort levels have to be taken into consideration. Will your client be able to tough out an investment in a basket of risky emerging market countries, as headlines forewarn of crisis, and as losses accumulate? Will she be able to stick with a collection of agency m-REITs levered 7 to 1, that sport frankenstein-like double-digit yields, as they fall in price? Will she have a basis for remaining confident that the losses she is incurring will be recovered in due course, that you haven’t missed something crucial in your assessment of the risks? No. So even though there may be a decent long-term return to be earned in these assets relative to plain-vanilla fixed income alternatives, investing in them is unlikely to work well in the present scenario, all things considered.
The Equity Space
The available fixed income opportunities aren’t particularly attractive, so we turn to the equity space. Investors in the equity space are currently wrestling with a number of worries:
China. As China’s credit and investment excesses unwind–a process that is already in motion–will the global economy be able to avert recession? If not, what will the implications for earnings be, particularly the earnings of multinationals? Given recent developments in China–a crashing stock market, abysmal economic data, unexpected currency devaluations–have policymakers lost control? Is China on the verge of a Lehman-like “moment of truth”, a point where conditions in its deeply-flawed, heavily-mismanaged economy finally break, unleashing a crisis?
Falling oil prices. Oil prices were supposed to have recovered by now. Yet they continue to bounce around the lows. If they stay where they are for the long-term, or worse, if they go lower, how severe will the losses for producers and lenders be? Energy investment has been a significant source of economic stimulus in the current expansion. As it gets scaled back, what will the effect on employment and growth be? What is going to step in to take the place of that investment, to keep the expansion going? Could the U.S. economy fall into a mild recession?
The Fed. For the duration of the current recovery, the Fed has provided consistent support for equity markets. Every time conditions have deteriorated, the Fed has come out of the woodwork, offering up both words and deeds designed to restore risk appetite. But that trend changed last fall, when QE3 was drawn to a final close. Equity market hasn’t been the same since.
The Fed’s ultimate concern is the job market, not the stock market. With the job market showing significant strength over the past year, a strength that wasn’t present in earlier phases of the recovery, the Fed has had more room to step back and let markets fend for themselves. That’s the approach that the Fed seems to be taking amid the current turmoil. Will the market be able to deal with it? Are prices going to have to reset lower?
The Fed seems intent on moving forward with a tightening this year, even as core inflation measures remain well below the 2% target. What is the Fed thinking? Why does it want to tighten so badly? Has it grown complacent about its mandate? If the Fed goes through with a rate hike in September or December, the risk is that the tightening will occur just as other headwinds in the global economy strengthen. Does the Fed appreciate that risk?
Markets don’t usually perform well when central banks start tightening. That would seem to be especially true for a market that is already six years into gains, up 200% from the lows. If the Fed is serious about tightening here, even against a lukewarm backdrop, what upside can U.S. equity market participants reasonably expect? After 7 years of acclimatization to a zero interest rate policy, a policy that has squeezed asset valuations to elevated levels, a progressive departure from that policy is going to represent a powerful headwind to further price appreciation.
What about the unforeseen effects? As Warren Buffet famously says, “only when the tide goes out do you discover who’s been swimming naked.” When the Fed finally comes off of zero, the tide will be going out on a substantial amount of ZIRP-related excess–not only domestically, but internationally. In the summer of 2013, we saw what a mild unwind of such excess can look like. Are there reasons to be confident that a similar unwind–or something worse–won’t play out again? The emerging-market concern is salient here, given the recent boom in dollar-denominated EM corporate debt issuance.
Earnings. Earnings for S&P 500 corporations continue to surprise to the downside. Year end 2015 estimates for S&P operating earnings now sit at $111, when they were $136 exactly one year ago today. That’s a full 20% drop–but the S&P has only fallen 10%. Is there any reason that it shouldn’t fall another 10%, to catch up?
You can blame the strengthening dollar. But with the Fed tightening, the BOJ and ECB aggressively easing, and emerging markets endlessly deteriorating, is there any reason to think that the dollar’s uptrend is over? You can blame lost oil revenues in the energy sector. But recall that a boost in consumer spending, prompted by falling gas prices, was supposed to offset those losses. That hasn’t happened. Why not?
Employment numbers have been strong, but the strength hasn’t translated into commensurate growth in output and revenues. It’s instead been absorbed into falling productivity. What are the implications of weak productivity for profitability? Are profit margin bears right? Are we in the early innings of an unwind of the profit margin boom of the last 10 years?
Adding to these worries, valuations, at least in U.S. equities, are unattractive. The current P/E ratio on the S&P 500–17.3 times trailing operating earnings and 19.4 times trailing GAAP earnings–is substantially elevated relative to both recent and long-term averages. That elevation is currently layered onto elevated profit margins–a dangerous combination, if they should both unwind together. In previous pieces, I’ve shared my reasons for expecting valuations and profit margins to remain elevated. But I certainly can’t make any guarantees on that front, nor would I deny that they have room to fall from current levels, even if they remain historically high.
You might think that valuations in Japanese or European equities are more attractive than equities in the U.S. But after the melt-ups those markets have recently seen, that’s no longer true–particularly if you adjust for differences in sector exposures. At present, the only segment of the international market that sports a genuinely attractive valuation is the emerging market segment–Brazil, Russia, Turkey, Greece, etc. If those countries are truly cheap (you never know until after the fact), there are excellent reasons for them to be cheap. They represent the epicenter of global risk. Their economies are a mess.
After the massive credit boom of the last decade, emerging markets appear due for a long period of adjustment, a period that is likely to be characterized by slow and challenged growth. But growth is the compensation that emerging markets are supposed to offer in exchange for weak governance, economic mismanagement, and political turmoil. Without it, what’s the point? What reason do investors have to be involved with the asset class? Right now, the biggest risk in investing in emerging markets is the currency risk, which can’t be cheaply hedged out. To bet on emerging market equities, you have to bet against the dollar. Given the backdrop, that doesn’t seem like a smart bet to make.
Holding Cash and Waiting
With the present cycle getting long in the tooth, what kind of upside is left? Is that upside attractive, given the risks? Not in my opinion. Nothing in the conventional investment universe is priced attractively relative to its risks–nothing in the fixed income space, nothing in the equity space.
You might therefore think that the right answer is to hold cash and wait for prices to come down. But how do you know they’re going to come down? And if they do come down, how will you know when to enter? It seems that in markets, the people that are inclined to wait, tend to always be waiting.
Given recent market turmoil, bears have become increasingly optimistic that they’re going to get the buying opportunity that they’ve been hoping for. I disagree. The worries that have provoked the market’s recent fall are legitimate and will likely represent headwinds to meaningful equity upside going forward, but the risk of deep losses–a grand buying opportunity–seems substantially overblown to me. Let’s look more closely at the worries:
China. With respect to China, none of the concerns are new. People have been raising them for over a decade. Ultimately, imbalances and excesses in an economy don’t have to mean a “crisis” or a “crash.” They can simply mean a long period of adjustment, with associated economic underperformance. That’s the path that China seems to be embarked on.
Ask yourself: what has really changed in China in the last few months, to fuel the present consternation? The answer, two dramatic headline events have occurred: (1) a crash in the stock market, and (2) a currency devaluation. These events have rekindled post-crisis disaster myopia, providing investors with a much-needed excuse to sell a market that had long been overdue for a correction. As time passes, and as disaster fails to ensue, investors will acclimatize to the travails of China’s adjustment. The fear of the unknown that recent headline events have provoked will blow over.
Many investors are interpreting the crash in the Shanghai composite as an omen of things to come. But that’s not a valid inference. Shanghai is a highly unsophisticated market–a casino of sorts, traded primarily by retail Chinese investors. In terms of the implications for the larger global economy, its movements might as well be meaningless. The fact it would eventually suffer a severe correction should come as a surprise to no one–it had rallied over 100% in only a few months.
Concerns have been raised that the crash will create knock-on effects in the Chinese economy, similar to what happened in the U.S. in 1929. But there’s a crucial difference to consider. China is an externally-managed economy, not a free market. If the Chinese economy slows excessively, the government will simply stimulate. Unlilke in the U.S., there are no political or legal obstacles to its ability to do that. The only potential obstacle is inflation–and inflation in China is well-contained.
The fact that China is an externally-managed economy, rather than a free-market, dramatically reduces the risk of a “Lehman-like” event. Lehman happened because the Fed couldn’t legally intervene, or at least didn’t think that it could. The Chinese government can intervene–and will, without hesitation. To accelerate the adjustment, it may allow certain parts of its economy to suffer. But it isn’t going to allow a crisis to develop.
China’s decision to devalue the yuan has stimulated fears of a 1998-style crisis. Those fears are superficial, unsupported by the facts. Currencies are not pegged to the dollar today in the way that they were in 1998. Sovereign reliance on dollar funding is not as prevalent. The countries that are pegged to the dollar, or that have borrowed in dollars, have much larger foreign currency reserves from which to draw. And so the risk of cascading devaluations and defaults is nowhere near as significant.
Investors forget that yuan’s real exchange rate to the dollar, and especially to the euro and the yen, has appreciated significantly over the last several years. That appreciation has hit competitiveness. With the Chinese economy slowing, the devaluation makes perfect economic sense–it’s will provide a needed boost to competitiveness, and a needed stimulus to the export sector. It would be happening if the currency weren’t pegged.
Oil. The U.S. economy saw oil price crashes in 1986 and 1998. As now, corporate earnings took a hit. But the stimulus of lower gas prices eventually kicked in, and earnings recovered. There were defaults and bankruptcies, and certain energy-dependent regions of the country slowed, but there was no credit contagion, no larger recession. What reason is there to expect a different outcome now?
In terms of the question of what will pick up the slack for lost energy investment, the answer is clearly housing. After a long period of post-crisis under-investment, that sector of the economy has ample room to run.
The Fed. Given the Fed’s skillful performance from late 2008 onward, we need to give it the benefit of the doubt. It’s not going to raise interest rates unless it’s absolutely confident that the economy can handle it. And, ultimately, if the economy can handle it, the market will be to handle it. As with all changes, the market will need to acclimatize to the Fed’s new policy stance. That may limit the upside, or even contribute to further downside. But there’s no reason to expect it to drive significant market losses, or to set a new recession in motion.
I personally think that the Fed will remain on hold through September, and maybe even through December. Two years ago this month, the Fed held off on the QE taper plans that it had been signalling to markets. The argument for holding off now, amid the current global market turmoil, seems much stronger than it was then.
It’s one thing to talk about doing something, it’s an entirely different thing to actually go and do it when the time comes. The decision as to when to finally pull the trigger on the first hike, in the aftermath of this long and painful recession, is easily the most important central-banking decision the members of this FOMC will ever make. They’re going to want the conditions to be right. If there are nagging uncertainties, the bias is going to be towards holding off.
The Fed has no compelling reason to tighten right now. Inflation risk is minimal. If it were to pick up, the Fed could quickly and easily quash it–and the Fed knows that. But there are strong reasons not to tighten, to wait. At a minimum, waiting would allow the Fed to get a better read on inflation–which is way below target. It would also be able to get a better reading on the impact that recent global weakness is having on the U.S. expansion. You can rest assured that as the moment of truth arrives, the doves on the FOMC–people like Charles Evans–are going to make that argument. And it’s going to be very compelling.
Earnings. The decline in earnings represents a known known. Crucially, the driver is not profit margin mean-reversion–profit margins ex-energy remain at record highs. The drivers are losses and asset writedowns in the energy sector, and dollar strength that has depreciated the foreign revenues of multinationals. Those factors, if they remain in place, are likely to continue to push back on price appreciation. But they’re unlikely to fuel a larger market downturn.
Picture the following scenario: the obligatory 10% correction is out of the way, we get past the historical danger periods of September and early October, the Fed decides to remain on hold, oil stabilizes, no disaster ensues for China, the global economy continues to muddle through, and the U.S. expansion, led by housing, continues to show strength. Can you see the market rallying back to the highs? I certainly can.
But can you see it going much farther? To me, it gets more difficult. By then, the market will be wrestling with the prospects of additional Fed tightening, the dollar will be strengthening further, creating additional headwinds on earnings, valuations will have become more stretched, as the cycle gets longer and longer in the tooth. My sense is that it’s going to be hard for investors to find the confidence to keep recklessly tacking on new highs against that backdrop, particularly after the recent turmoil. The market needs to spend a few years going nowhere.
Now, picture another scenario: global headlines continue to deteriorate, and we fall another 15%, to around 1650. Do you not think there will be a substantial number of sidelined investors eager to get in at that price, eager for a second chance to participate in the potential 30% rally back to the highs? I certainly do. A move to 1650 would represent almost a 25% correction. That would be a deeper correction than the worst correction that the market suffered during the pre-Lehman portion of the 2008 recession, nine months in. If market participants retain any kind of confidence in the outlook for the U.S. economy, they aren’t going to let the market fall to that level–at least not for very long.
What we have, then, is a market with limited upside–a market that could go back to the highs over the next 12 months, but that seems unlikely to be able to go much farther–and limited downside–a market that seems unlikely to completely unravel, at least by more than, say, another 15%.
Solution: Deep In the Money Covered Calls
The best available solution to the current investment conundrum, in my view, is to sell long-dated out of the money put options on the S&P 500. Selling out of the money put options is a structural source of alpha in markets–investors are behaviorally inclined to pay more for them than they’re actually worth. Obviously, selling them isn’t always a smart strategy–the price and the backdrop matter. But right now, with the volatility index spiking over exaggerated fears, you’ll be hard pressed to find a better investment.
The following table shows the prices of September 2016 $SPY puts at various strikes. The returns quoted are the returns that you will earn if the price at expiration is above the strike price.
To sell a put option in an IRA account, you have to set aside a full cash reserve to buy the equity, in case the option gets executed. In theory, you are free to earn interest on that cash. But you can only earn what your broker pays. Unfortunately, at present, your broker is probably paying something very close to zero.
It’s possible to construct the functional equivalent of a put option at a given strike price by selling covered call options at that strike price–going long the equity at the market price, and then selling calls at the strike price. Deep in the money covered call options, which mirror out of the money put options, provide a return from premium and a return from the dividends that accrue to the seller over the time horizon. By put-call parity, the difference between that return and the premium offered by the corresponding out of the money put option should equal the interest rate earned on the cash, plus a premium to cover the risk of the early exercise of the call option, which will deprive the seller of subsequent dividends.
Right now, the difference seems large. The deep in the money covered call option would therefore seem to be the more attractive choice, especially given that the cash held on reserve to secure the put option won’t be able to earn any interest in an IRA, and that the last dividend that accrues to the deep in the money covered call option will be paid three months before expiration, increasing the cost of exercising the call early so as to receive the dividend. If the holder of the call chooses to exercise the call before expiration in order to receive the dividend, preventing us from receiving it, fine–we will be “freed” from a 12 month commitment three months early.
So consider the following strategy. You take the $1,000,000 in the IRA and sell 60 September 2016 $SPY call contracts at Friday’s closing bid price of 33.55, simultaneously buying 6,000 shares of the $SPY ETF at Friday’s closing ask price of 192.59. If the S&P remains above 1650 at expiration, the calls will be executed, your shares will be sold away, and your one-year return will be 6.05%, or $60,500. That includes $SPY’s ~$4.00 annual dividend, which you will collect in four payments over the one year period, to be paid this month, in December, in March, and finally in June. In exchange for the 6.05% return, you will have to bear the risk of the S&P 500 below 1650. If the index ends up below 1650, the call contract that was “hedging” your downside will expire worthless, and you will be left holding $SPY shares without protection. However much the index happens to have fallen below 1650, the losses will be yours.
In assessing the attractiveness of 1650 as a price, our tendency is to think back to when the S&P was last at that price. The S&P was last at 1650 in the fall of 2013, during the trough of the debt ceiling crisis. So, not very long ago. But we have to remember that since then, the companies in the S&P 500 have retained substantial earnings–about $130 per share in GAAP EPS. If current earnings trends hold up through expiration in September of next year, the total retained earnings will have amounted to almost $200. Those earnings, which are still “in” the companies in the form of cash on the balance sheet, shrunken share count from buybacks, and growth from capex, represent real value that needs to be factored into the assessment.
From September of 2013 to expiration in September of 2016, the CPI will have increased by around 5% on a core basis. Given that equities are a real asset, a claim on the output of real capital, that increase needs to be factored in as well. So we use real, inflation-adjusted numbers.
To incorporate the value of retained earnings into comparisons of an index’s prices over time, we can add back cumulative retained earnings to the actual prices observed at prior dates. Let me try to explain how that would work. Suppose it’s September 2016, and we’re comparing the S&P’s current hypothetical price of 1650 to it’s price in September of 2013, which was also 1650. We might think that because the prices are the same, that the respective values are the same. But over the period, the S&P retained $200 in earnings. What that means is that the 2016 S&P has $200 more in value inside it than the 2013 S&P had. To correct for that difference, we add the $200 back to the September 2013 price, to make it appear appropriately more expensive.
Making that adjustment, we find that the S&P 500 in September of 2013 was at a value corresponding to something closer to 1850, in comparison with the current price of 1650. Though the actual prices were the same, the true price now is cheaper than the true price was then, by roughly $200–the amount that was earned and retained in the interim.
Retained EPS adjustment works in the same way as inflation adjustment. When we adjust for inflation, we raise past nominal prices to reflect what those prices would mean in today’s terms. Similarly, when we adjust an index for retained EPS, we raise its past nominal prices to reflect what those prices would mean in today’s terms–relative to the value that exists in the index now, given the retained earnings.
The following chart normalizes the real prices of the S&P 500 to reflect cumulative retained EPS using a September 2016 basis:
The blue line (left-axis) is the real, inflation-adjusted price of the S&P 500 with retained EPS added back to prior dates to make them look appropriately more expensive. The green line (right-axis) is the actual nominal price that the index traded at on the given date. In asking the question, what is it like, from a valuation perspective, to buy the S&P at 1650 in September of 2016, we look for those past dates where the real price of the index, adjusted for retained EPS using a September 2016 basis, was 1650. Those are found in the places where the blue line intersects with the red line. I’ve boxed them in black. To get an idea of what it would be like, from a valuation perspective, to buy the S&P at 1650 in September of 2016, we look at what the actual nominal prices (green line) were on those dates, and use those as a point of reference.
So, with the value of retained EPS appropriately accounted for, buying the S&P at 1650 in September of 2016 would have been “kind of like” buying the S&P at 1335 in May of 2012, or at 1300 in January of 2012, or at 1260 in June of 2011, or at 1185 in October of 2010, or at 1150 in March of 2010. We can argue over how attractively valued the market was on those dates, but everyone will agree that it was substantially more attractively valued then than it is now, or than it’s been at any time in the last three years.
Another way to assess the value is to simply look at the extent of the decline from the peak. The following table shows the declines for the various strike prices:
A price of 1650 (165 for the $SPY) would represent a 22.5% correction from this year’s highs, and a 14.3% correction from Friday’s close. Those are pretty fat corrections to serve as buffers. Unless you believe the bull market is over, a 6% annual return in exchange for owning the risk below them seems like a pretty good trade, especially given the lack of alternatives.
Of course, for investors that are more conservative, strike prices that carry less risk–but that still offer an attractive return–are available. To offer an example, you could earn roughly 4% in exchange for taking on the S&P’s risk below 1350. Is it realistic to expect the current China-related turmoil to fuel a correction all the way down to 1350, 37% from the peak? If so, I wouldn’t mind being forced to buy.
The 10 year treasury yields roughly 2%. That return comes with meaningful duration risk. If long rates rally by 100 bps, back to where they were at the end of 2013, you will lose roughly 10% on the price change. If they rally 200 bps, near where they were in late 2009, you will lose roughly 20%. Contrast that risk-reward proposition with the risk-reward proposition of a one year deep in the money covered call at a strike price of 1350. There’s no interest rate risk in that investment. There’s only price risk–the risk that the S&P will have corrected by more than 37% from this year’s highs one year from now. In exchange for taking it, you earn double the treasury return.
To further gauge the value, we can look at the Shiller CAPE values at the various strike prices:
At 1650 in September of 2016, the S&P will be trading at a Shiller CAPE (GAAP) of 20.35–a value very close to the Shiller CAPE values observed on the dates that we analogized the 1650 level to earlier, using real retained EPS adjustments. The fact that the Shiller CAPE values are all roughly the same confirms that the adjustment technique is valid:
Using the real reversion technique, and conservatively assuming a mean-reversion in the Shiller CAPE to the post-war average of 17 (a value that the measure has spent less than 5% of its time at over the last 25 years), the implied 10 year total return on the S&P 500 from a September 2016 price of 1650 will be roughly 4% real, 6% nominal. That’s a reasonably attractive return, given the alternatives. At 1350, the implied 10 year total return will be roughly 6% real, 8% nominal–roughly in line with the historical average, and very attractive relative to the alternatives.
Now, there are two major risks to selling out of the money put options or deep in the money covered call options. Let’s think more carefully about them:
First, the market could go substantially lower than our strike–it could crash. If that were to happen, we would lose money. But on the bright side, we would lose substantially less money than our fellow long investors, who would get destroyed. Moreover, we would have bought the market at an attractive valuation relative to recent past averages. Importantly, because we aren’t using leverage, we would be able to stay with the position. Over time, the position would recover and produce a decent return–not spectacular, but decent.
Second, the index could stay above the strike, but fall from its current value, presenting a buying opportunity that we might want to take advantage of, but that we won’t be able to, at least not without closing out the option trade and taking a loss. Unless adequate time passes, generating sufficient option decay, a falling market will put the option trade in the red.
But being realistic, if we choose to hold cash instead of putting on the option trade on, we probably won’t succeed in capitalize on the hypothetical opportunity anyway. Whenever the bottom comes, we’ll surely miss it, and then we’ll refuse to buy the market as it moves higher, given the fact that we could have bought it lower, and that it could easily fall back down to where it was. Note that if we do put the option trade on, and we decide to take a loss on it to capitalize on some other opportunity, the loss isn’t going to be very large–at most, a few hundred basis points. We’ll be happy at the fact that we’ll be trading into something better.
Investing is about converting time into money. The best way to convert time into money in an equity environment where there isn’t much near-term downside or upside, where fear has spiked, and where participants are willing to overpay for insurance, is to sell that insurance. On average, over time, those that employ a strategy of selling insurance will fare better than those that wait and try to catch bottoms.
Empirical Evidence: Put-Write [Post-Mortem]
The CBOE keeps an index, called the put-write index, which tracks the performance of a strategy of selling, on a monthly basis, at the money one-month put options on the S&P 500. The following chart shows the performance of the put-write strategy ($PUT) relative to buy and hold, from January 1990 to January of 2015:
As you can see, the strategy of selling put options wins out over buy and hold, at least on a pre-tax basis. The outperformance suggests that market participants overpay for protection relative to what it’s actually worth. On average, whoever was buying the options that the put-writers were selling was making a mistake.
Now, in the initial version of this piece, I proposed a strategy–called $PUT Switching–designed to switch into and out of the put-write strategy based on option valuation. The strategy worked as follows. If the monthly close of the volatility index (VIX), the best proxy for option valuation, is above 20, then for the next month, you invest in the put-write strategy. If the monthly close of the volatility index is below 20, then for the next month, you buy and hold the index.
I illustrated the performance of $PUT Switching in the following chart:
Astute reader @econompic e-mailed in to communicate that he was unable to reproduce this result. So I took a closer look. I realized that I was carelessly using Robert Shiller’s spreadsheet to build the S&P 500 total return index. That’s a mistake in this context, because the monthly prices in that spreadsheet are not closing monthly prices, they are the average of the high and low prices of the month. The strategy, then, was transacting at hypothetical “average” prices that were not concretely available to buyers and sellers at the assumed time of transaction. That’s cheating.
The strategy is supposed to look at the VIX at the close of the month, and then transact into or out of the market at the closing price for that month, holding until the close of the next month. What it was actually doing, given my use of Shiller’s data as the basis for the S&P’s total return index, is looking at the VIX at the close of the month, and then transacting into and out of the market at the average of the high and low price of the month. There’s an inherent retrospective bias in that construction, a bias that artificially boosts the performance of the strategy.
If the VIX is high at the close of the month, conditions are probably bearish, and therefore the price at the close of the month is probably going to be lower than the average price for the month. If I model the strategy as transacting at the average price for the month, rather than at the closing price, I will probably be giving the strategy a better price at which to switch out of the market than would have actually been available to it at the time of the decision to switch. The same is true in the other direction. If the VIX is low at the close of the month, conditions are probably bullish, and therefore the price at the close of the month is likely to be higher than the average price for the month. If I model the strategy as transacting at the average price for the month, rather than at the closing price, I will probably be giving t he strategy a better price at which to switch into the market than would have actually been available to it at the time of the decision to switch.
Unfortunately, that mistake explains most of the apparent outperformance that you see in the chart above. The following chart corrects the mistake, using an S&P index of exact monthly closing prices:
The 4% annual excess return falls to 1%, with the bulk of the outperformance clustered in the most recent cycle. Hardly as impressive. My apologies!
I stand behind everything else I said. The VIX closed on Friday at 27, double the average of the last three years. If its current elevation is a sign that the market is headed for a deeper downturn, then fine. We’ll do much better selling out of the money puts or deep in the money covered calls than we will going long equities. If we’re eventually forced to buy into the market, we’ll be buying at a price that we’re comfortable with, maybe even excited about–as opposed to the current price, which is uninspiring. If the VIX’s current elevation doesn’t mean anything, if it’s just a symptom of an overdone market trying to correct itself, using headline events as the excuse, then even better. We’ll get paid handsomely to insure against exaggerated risks that aren’t going to come to fruition.
(Disclaimer: The information in this piece is personal opinion and should not be interpreted as professional investment advice. The author makes no representations as to the accuracy, completeness, suitability, or validity of any of the information presented.)
(Disclosure: Long $SPY, short January 2016 170 calls, short September 2016 160 calls.)
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