Harvesting Risk Adjusted Gains in Bullish US Equity Markets
Consistently harvesting positive gains is difficult. In markets where risks remain rife, that task gets harder. That’s where tactical hedging during periods of elevated risk help improve risk adjusted returns.
Analyst forecasts are for US equity performance to be neutral to bullish in 2024. Some believe that returns are likely to be dragged lower given the massive run-up in the final two months of 2023. Occurrence of a recession in 2024 could result in a sharp correction. Yet, a successful soft-landing combined with rate cuts by the Fed may drive markets even higher.
Uncertainty also persists over the upcoming US election. Election years generate an average of +7.3% returns over the last sixteen US elections. However, they also drive volatility.
Uncertainty is the only certainty for 2024. As seasoned investors and portfolio managers, forecasting is a fool’s errand. On any given day, time in the market is always better than timing the market.
ETFs could be a cost-effective way to gain exposure to the S&P 500 index, and they distribute dividends as well. Downside risks can be managed using CME’s short-dated equity index options around key economic events while maintaining a bullish stance on S&P 500.
US EQUITIES TO RALLY IN 2024 BUT NOT BY MUCH ACCORDING TO ANALYSTS
Most analysts are bullish on the S&P 500. Given a turbo charged finish in 2023, optimism remains muted on further upside gains as uncertainty persists.
The colossal run-up in the S&P 500 and Nasdaq-100 over November and December has raised concerns of the market running ahead of itself on over expectations. The S&P 500 is 13.5% higher since 1/Nov while Nasdaq-100 has rallied 14.7%.
Yardeni Research, Oppenheimer, and Goldman remain bullish while JP Morgan and Morgan Stanley expect the benchmark index to give away some of the run-up during November and December due to high valuations, rising geo-political risks, and recession.
Oppenheimer believes market views of rate cuts in the first half of the year may be too optimistic. If Fed disappoints on rate timing and size of rate cuts, S&P 500 could witness drawdowns.
2023: A YEAR IN REVIEW
While inflation was stubborn all year, so was economic growth. US GDP growth in 2023 far surpassed expectations. Back in March, the Fed anticipated GDP growth between -0.2% to 1.3% in 2023. Come December, the Fed now anticipated GDP growth of 2.5% to 2.7%.
Inflation cooled much faster. Fed’s downward revision of inflation expectations points to peak interest rates. Amid the dovish outlook at its December meeting, markets rallied sharply in anticipation of accommodative monetary policy in 2024.
ANALYST MISSED 2023 S&P 500 TARGETS BY A SIGNIFICANT MARGIN
The final close of the S&P 500 was sharply higher than the most bullish forecasts from major banks at the start of 2023. The index was trading in the upper part of the forecast range for most of 2023 and squarely within the forecast range by HSBC, Goldman, and Citi until June.
Optimism of soft landing & on rising rate expectations drove the index well above the forecasts.
ELECTION YEAR IN THE US USUALLY DELIVERS POSITIVE RETURNS BUT UNCERTAINTY A RISK
2024 is an election year in the US. Election years on average deliver positive returns of +7.3% since 1960. Election years since 1960 have delivered positive returns 81.3% of the time compared to 68.8% for non-election years.
The results diverge for election years in which Democrats are elected (+5.6% returns) compared to Republicans (+8.9% returns).
Historical volatility during election years has been higher (18.6%) compared to non-election years (17.8%). However, the trading range during election years was marginally narrower (29.6% from low to high) compared to non-election years (29.9% from low to high).
Election years are generally viewed positively by markets but also tend to underperform relative to non-election years.
TIME IN THE MARKET TRUMPS TIMING THE MARKET
“Time in the market” has historically trumped “timing the market”. Staying invested for longer increases the likelihood of positive returns. Timing is hard, doing so consistently is even harder.
Putnam Investments research shows that staying fully invested in the S&P 500 between 2008 to 2023 would deliver strong annualized returns of 10.6%. However, missing the 10 best days of the index during those 15 years would lead to annualized returns just half of that.
Instead of actively managing allocation towards equity indices in a portfolio, investors can opt to hold low-fee index fund ETFs such as SPDR S&P 500 ETF Trust (SPY) or iShares Core S&P 500 ETF (IVV), which offers:
• Low capital requirements relative to replicating index returns
• Decent dividend yield: SPY offers 1.39% dividend yield in 2023 while IVV delivered 1.44%
• Low expense ratios: SPY expense ratio is mere 0.09% while IVV charges a meagre 0.03%
To protect against drawdowns, investors can deploy long put positions on short dated Micro E-Mini S&P 500 (MES) options. Long puts on weekly MES options can protect against downside risk with relatively low premium. This makes them effective in managing event-driven risk.
KEY EVENTS CALENDAR 2024
Mint previously covered event-driven volatility within oil markets. Like oil, event driven volatility can cause outsized moves in equities too. For instance, in November upon the CPI release that showed inflation cooling, S&P 500 jumped 1.9%. Similarly, events can cause downside moves as well. In September, after a hawkish FOMC meeting, the index tanked 1.6%.
FOMC meetings and economic releases during 2024 could result in sharp moves in US equity markets, especially if they diverge from market expectations. Investors can trade the economic calendar by deploying short-dated options around these events.
CME offers weekly micro S&P 500 options for each day of the week. For the FOMC meeting outcome, which is released every Wednesday, the Wednesday or Thursday weekly options can be utilized. Similarly, CPI releases are typically on Tuesday-Thursday. Nonfarm payrolls are released on the first Friday of each month.
Put option premiums is a cost that can chip away at returns. Long-dated coverage during period of muted risk can result in wasted premiums. Instead, investors can focus their short-term hedges around the pivotal economic releases such as FOMC meetings to limit drawdowns.
ESTABLISHING TACTICAL HEDGES AROUND KEY EVENT RISKS
To maximize gains from long position in S&P 500 index funds, investors can tactically deploy short-dated CME Options on Micro E-mini S&P 500 Futures (“Micro S&P Options”) around key economic releases as well as FOMC meetings. Micro S&P Options offer low cost in premium and delivers downside protection from index drawdowns.
CME Group offers short-dated options on Micro E-Mini S&P 500 futures with expiries on Monday, Wednesday, Thursday, and Friday. Each weekly contract offers exposure to 1 MES futures contract or 5-times the index value.
In the lead up to key events, a portfolio manager will need to assess the notional value of their ETFs holdings and match it against the required number of options.
As an illustration, considering a long position in SPY on 2/Jan at an entry of USD 475.29; each SPY share offers exposure to 1/10th of the index value. To match notional value of the long ETF leg with the put options, 50 shares of SPY are required.
Based on data as of close of markets on 29/Dec/2023, weekly MES options points to an IV of 11% for ATM strikes. In case investors opt to acquire the weekly option a week prior to the economic release (7 days-to-expiry), the option would cost ~USD 150 (30 x 5) equating to 0.6% of the notional value.
If the index drops more than 0.6%, investors are protected from downside on their long ETF leg. However, where the decline is smaller than 0.6% or index rises following the release, cost of protection remains a cost to investor.
ILLUSTRATIVE EXAMPLE
As a hypothetical example, assume that the highest S&P 500 target for 2024 (Yardeni’s USD 5,400) is reached by the end of the year.
The path to the target is likely to vary with ups and downs. Assuming that 50 shares of SPY are acquired each month while implementing tactical hedges around FOMC meetings. Market performance and FOMC meeting performance is assumed to be randomly distributed based on past market performance.
The following table shows the net profit this strategy would generate through 2024 with and without the tactical hedges.
In the above example, the options hedges yield a net profit due to large hypothetical downside moves in July and September. In case the downside moves do not occur, the options legs would expire worthless and yield a net loss.
IN CONCLUSION
Signal of a Fed Pivot points to a bullish US equity market in 2024. However, raft of risks remains in sight across the horizon.
Prudent investors know well that investment gains are harvested by ensuring time in the market rather than timing the market. However, prudence also requires that exposures be astutely managed using tactical hedges that optimizes benefits versus costs of securing downside protection.
Here’s wishing all portfolio managers long returns and short risk going into 2024.
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com/cme/.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
Analyst forecasts are for US equity performance to be neutral to bullish in 2024. Some believe that returns are likely to be dragged lower given the massive run-up in the final two months of 2023. Occurrence of a recession in 2024 could result in a sharp correction. Yet, a successful soft-landing combined with rate cuts by the Fed may drive markets even higher.
Uncertainty also persists over the upcoming US election. Election years generate an average of +7.3% returns over the last sixteen US elections. However, they also drive volatility.
Uncertainty is the only certainty for 2024. As seasoned investors and portfolio managers, forecasting is a fool’s errand. On any given day, time in the market is always better than timing the market.
ETFs could be a cost-effective way to gain exposure to the S&P 500 index, and they distribute dividends as well. Downside risks can be managed using CME’s short-dated equity index options around key economic events while maintaining a bullish stance on S&P 500.
US EQUITIES TO RALLY IN 2024 BUT NOT BY MUCH ACCORDING TO ANALYSTS
Most analysts are bullish on the S&P 500. Given a turbo charged finish in 2023, optimism remains muted on further upside gains as uncertainty persists.
Source – Business Insider
The colossal run-up in the S&P 500 and Nasdaq-100 over November and December has raised concerns of the market running ahead of itself on over expectations. The S&P 500 is 13.5% higher since 1/Nov while Nasdaq-100 has rallied 14.7%.
Yardeni Research, Oppenheimer, and Goldman remain bullish while JP Morgan and Morgan Stanley expect the benchmark index to give away some of the run-up during November and December due to high valuations, rising geo-political risks, and recession.
Oppenheimer believes market views of rate cuts in the first half of the year may be too optimistic. If Fed disappoints on rate timing and size of rate cuts, S&P 500 could witness drawdowns.
2023: A YEAR IN REVIEW
While inflation was stubborn all year, so was economic growth. US GDP growth in 2023 far surpassed expectations. Back in March, the Fed anticipated GDP growth between -0.2% to 1.3% in 2023. Come December, the Fed now anticipated GDP growth of 2.5% to 2.7%.
Inflation cooled much faster. Fed’s downward revision of inflation expectations points to peak interest rates. Amid the dovish outlook at its December meeting, markets rallied sharply in anticipation of accommodative monetary policy in 2024.
ANALYST MISSED 2023 S&P 500 TARGETS BY A SIGNIFICANT MARGIN
The final close of the S&P 500 was sharply higher than the most bullish forecasts from major banks at the start of 2023. The index was trading in the upper part of the forecast range for most of 2023 and squarely within the forecast range by HSBC, Goldman, and Citi until June.
Optimism of soft landing & on rising rate expectations drove the index well above the forecasts.
ELECTION YEAR IN THE US USUALLY DELIVERS POSITIVE RETURNS BUT UNCERTAINTY A RISK
2024 is an election year in the US. Election years on average deliver positive returns of +7.3% since 1960. Election years since 1960 have delivered positive returns 81.3% of the time compared to 68.8% for non-election years.
The results diverge for election years in which Democrats are elected (+5.6% returns) compared to Republicans (+8.9% returns).
Historical volatility during election years has been higher (18.6%) compared to non-election years (17.8%). However, the trading range during election years was marginally narrower (29.6% from low to high) compared to non-election years (29.9% from low to high).
Election years are generally viewed positively by markets but also tend to underperform relative to non-election years.
TIME IN THE MARKET TRUMPS TIMING THE MARKET
“Time in the market” has historically trumped “timing the market”. Staying invested for longer increases the likelihood of positive returns. Timing is hard, doing so consistently is even harder.
Source - Putnam Investment
Putnam Investments research shows that staying fully invested in the S&P 500 between 2008 to 2023 would deliver strong annualized returns of 10.6%. However, missing the 10 best days of the index during those 15 years would lead to annualized returns just half of that.
Instead of actively managing allocation towards equity indices in a portfolio, investors can opt to hold low-fee index fund ETFs such as SPDR S&P 500 ETF Trust (SPY) or iShares Core S&P 500 ETF (IVV), which offers:
• Low capital requirements relative to replicating index returns
• Decent dividend yield: SPY offers 1.39% dividend yield in 2023 while IVV delivered 1.44%
• Low expense ratios: SPY expense ratio is mere 0.09% while IVV charges a meagre 0.03%
To protect against drawdowns, investors can deploy long put positions on short dated Micro E-Mini S&P 500 (MES) options. Long puts on weekly MES options can protect against downside risk with relatively low premium. This makes them effective in managing event-driven risk.
KEY EVENTS CALENDAR 2024
Mint previously covered event-driven volatility within oil markets. Like oil, event driven volatility can cause outsized moves in equities too. For instance, in November upon the CPI release that showed inflation cooling, S&P 500 jumped 1.9%. Similarly, events can cause downside moves as well. In September, after a hawkish FOMC meeting, the index tanked 1.6%.
FOMC meetings and economic releases during 2024 could result in sharp moves in US equity markets, especially if they diverge from market expectations. Investors can trade the economic calendar by deploying short-dated options around these events.
CME offers weekly micro S&P 500 options for each day of the week. For the FOMC meeting outcome, which is released every Wednesday, the Wednesday or Thursday weekly options can be utilized. Similarly, CPI releases are typically on Tuesday-Thursday. Nonfarm payrolls are released on the first Friday of each month.
Put option premiums is a cost that can chip away at returns. Long-dated coverage during period of muted risk can result in wasted premiums. Instead, investors can focus their short-term hedges around the pivotal economic releases such as FOMC meetings to limit drawdowns.
ESTABLISHING TACTICAL HEDGES AROUND KEY EVENT RISKS
To maximize gains from long position in S&P 500 index funds, investors can tactically deploy short-dated CME Options on Micro E-mini S&P 500 Futures (“Micro S&P Options”) around key economic releases as well as FOMC meetings. Micro S&P Options offer low cost in premium and delivers downside protection from index drawdowns.
CME Group offers short-dated options on Micro E-Mini S&P 500 futures with expiries on Monday, Wednesday, Thursday, and Friday. Each weekly contract offers exposure to 1 MES futures contract or 5-times the index value.
In the lead up to key events, a portfolio manager will need to assess the notional value of their ETFs holdings and match it against the required number of options.
As an illustration, considering a long position in SPY on 2/Jan at an entry of USD 475.29; each SPY share offers exposure to 1/10th of the index value. To match notional value of the long ETF leg with the put options, 50 shares of SPY are required.
Based on data as of close of markets on 29/Dec/2023, weekly MES options points to an IV of 11% for ATM strikes. In case investors opt to acquire the weekly option a week prior to the economic release (7 days-to-expiry), the option would cost ~USD 150 (30 x 5) equating to 0.6% of the notional value.
If the index drops more than 0.6%, investors are protected from downside on their long ETF leg. However, where the decline is smaller than 0.6% or index rises following the release, cost of protection remains a cost to investor.
ILLUSTRATIVE EXAMPLE
As a hypothetical example, assume that the highest S&P 500 target for 2024 (Yardeni’s USD 5,400) is reached by the end of the year.
The path to the target is likely to vary with ups and downs. Assuming that 50 shares of SPY are acquired each month while implementing tactical hedges around FOMC meetings. Market performance and FOMC meeting performance is assumed to be randomly distributed based on past market performance.
The following table shows the net profit this strategy would generate through 2024 with and without the tactical hedges.
In the above example, the options hedges yield a net profit due to large hypothetical downside moves in July and September. In case the downside moves do not occur, the options legs would expire worthless and yield a net loss.
IN CONCLUSION
Signal of a Fed Pivot points to a bullish US equity market in 2024. However, raft of risks remains in sight across the horizon.
Prudent investors know well that investment gains are harvested by ensuring time in the market rather than timing the market. However, prudence also requires that exposures be astutely managed using tactical hedges that optimizes benefits versus costs of securing downside protection.
Here’s wishing all portfolio managers long returns and short risk going into 2024.
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com/cme/.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
Full Disclaimer - linktr.ee/mintfinance
