Options markets are flashing warnings to stocks investors after the current rally.
Our Markets Take
Financials are a critical part of the recovery plan and if one believes their reserves are sufficient, it may time to start looking at these names more seriously. The market’s optimism towards the US economic reopening is a situation with no playbook: any and all all outcomes are possible. Our approach is to risk manage for the extremes and not the base case. Return of capital, not return on capital should be the tactic in fixed income. In stocks, we focus on global diversification on both end-market customers as well as supply chains to find the survivors and winners. Despite VIX above 40, SPY puts look as interesting as they have in a while. Bear market rallies are tempting but the global pandemic and economic crisis are still likely in the first quarter of their histories. Focus on building resiliency into portfolios by removing low quality-high speculative investments and funds that may have recovered in this bear market rally.
Correlations remain high according to our in-hose index despite the rally in stocks. Utilities Select Sector SPDR ETF (XLU), SPDR Gold Shares (GLD), iShares National Muni Bond ETF (MUB) and Invesco CurrenyShares Swiss Franc Trust (FXF) returns have been powerful month to data showing defensive investors have been looking to expand diversification away from long treasuries and short credit. There is a distinct flavor of conservatism and worry about the US Dollar in those moves. We see SPDR Gold Shares (GLD) $180 as a possible result in 2020. MUB is controversial to folks but if the FED will stand behind muni access to the markets they look like a reasonable way to get some yield. We also think Invesco CurrencyShares Japanese Yen Trust (FXY) (the Yen) would be a solid addition to portfolios to get some protection against further virus bad news in Asia.
We think managing portfolios for continued high volatility and high correlation makes sense here despite what the bear market rally is communicating. The tremendous amount of support the FED and authorities are installing reduces liquidity risks but can do nothing to resolve the medical and virus risks. The virus cycle creates a feedback loop that could lead to fits and starts economic behavior until testing, treatment, and vaccines are developed. Multiple scenarios are viable and as such positioning portfolios for one shape of recovery makes no sense. Resilient portfolios aren’t simply created by reducing volatility but by synergistically adding pieces with reliable negative or low correlations.
Throughout this note, we discuss the following ETFs:
- SPDR S&P 500 ETF Trust (SPY)
- iShares iBoxx High Yield Corporate Bond ETF (HYG)
- Invesco CurrenyShares Swiss Franc Trust (FXF)
- Invesco CurrencyShares Japanese Yen Trust (FXY)
- SPDR Gold Shares (GLD)
- VanEck Vectors Gold Miners ETF (GDX)
- Financials Select Sector SPDR ETF (XLF)
- Utilities Select Sector SPDR ETF (XLU)
- iShares National Muni Bond ETF (MUB)
How to Play the US Stock Market
• SPY put spreads look interesting in the May or June side. Keep them wide enough to target a 5 to 1 return if we move back towards a possible $240 partial retracement. SPY implied volatility looks 41% cheap to forecast. Not a screaming value but fairer than they’ve been for a while. If we put any stock in the IMF warnings all clear equity optimism may be premature.
• HYG puts still look opportunistic on this recovery. Target HYG mid $70s for a fear or bad news hedge. Financials’ major reserving means loan values are going to start being written down. In that environment HY bonds could similarly suffer. We think the FED matters for keeping markets liquid but we don’t think they want to set price.
Buy the Banks as a Hedge to Bearish Bets on US Stocks and Credit
• KRE and XLF are trading at levels that may make these lockbox stocks. Now that the shock around banks reserves are of the way, and the expectation that many of these stocks are maintaining their dividends shouldd help these stocks find a price bottom here. In regional banks, it doesn’t make a ton of sense to stock pick unless you really know their credit book. Find a great regional bank fund or use KRE. The very large financials like JP Morgan, Bank of America BAC , Morgan Stanley MS , and Goldman Sachs GS are likely to grow their balance sheets to new levels in this crisis. Stocks like JP Morgan, Bank of America and the other majors often have a 90%+ correlation to XLF so pick a few quality names and save yourself a management fee. These names are a vital part of the recovery plan in getting credit out and the broad analyst coverage advantages those names. With stocks’ volatility and the newsflow critical we’d be very tactical and incremental about the buying in financials.