Despite the perception of Fed support, credit pull backs are a natural response. The fear/greed relationship is slowly moving back towards fear with growing concerns over economic growth, geopolitical, valuation and extended behavior concerns. Bankrupt company stocks rallying environment gives surreal quality to the recovery rally and we think investors should take notice.
The CBOE Volatility Index (VIX) hasn’t been able to get under 24 despite rallying back to over flat on the year and CBOE implied volatility is still over 60. Equity put strategies make sense. Position for equity declines in China and flight from Hong Kong as China seeks to control the negative spin. Our list of negative catalysts into this summer is long but here are just a few:
Catalysts for market vulnerability
- Datapoints from reopening demand may wane after initial reopen surge. Businesses that reopen may also find that they are not profitable at 50% occupancy. Covid case consequences on consumer behavior and confidence remain uncertain.
- Additional stimulus uncertainties – Political parties are still far apart on the next bill and summer vacations and a perception of better than expected reopenings may bog the process down. An inability to get more money to small businesses, Americans, and municipalities could affect confidence in recovery support.
- Notable bankruptcy announcements are starting to come at a faster pace and could become a weight to sentiment rather than a reason to buy their stock.
- Earnings concerns and fear of no earnings guidance despite better reopening expectations. At some point even retail investors will recognize the foolishness of buying with no information.
- Global datapoints and potential trade war escalation with China could endanger sentiment showing economic recovery and will not be as optimistic as expected. OECD warnings of a 6% economic slump could turn into -7.6% if a second wave of Covid-19 is not well controlled. While Hong Kong may not seem meaningful, its significance as a pathway to Chinese transparency and human rights progress affects capital flows to and from China.
- Sentiment looks extended vs remaining uncertainty – The Put/Call ratio is at 9-year lows. In layman’s terms that means investors are as bullish as they have been. That makes protection reasonable and we think investors will start positioning for a pullback.
- iShares iBoxx $ High Yield Corporate Bond ETF (HYG) – Offers the best payout. There is a belief the Fed put eliminates the risk in HYG. Our belief is the Fed put is there to provide liquidity when necessary but won’t be there to protect price. Look at August 77-68 Put spread: 7-16% Put spread, ~14 to 1. HYG 2m IV is in its 77th percentile and 6% expensive to forecast. 2m Skew is 0.61 standard deviations below its mean.
- iShares Russell 2000 ETF (IWM) – Performance, realized volatility and covariance suggests IWM will be more vulnerable vs SPY should there be a retracement. Payouts are not as high, but downside risk may outweigh differences in pricing. Look at August 135-110 Put spread, 10-27%: ~7 to 1. IWM 2m IV is in its 76th percentile and 6% cheap to forecast. 2m Skew is fair.
- SPDR S&P 500 Trust ETF (SPY) – Although large cap ultimately may be less vulnerable, SPY has rallied to nearly unchanged on the year and it is undeniable that vol is cheaper and payouts are more attractive. Look at August 280-250 Put Spread, 13-22%, ~11.4 to 1. SPY 2m IV is in its 73rd percentile and 6% cheap to forecast. 2m Skew is 0.54 standard deviations below its mean.
- iShares China Large-Cap ETF (FXI) and iShares MSCI Hong Kong Index Fund (EWH) – We see vulnerability in both these ETFs as a result of a potential roll over of growth and we see Hong Kong as at risk for further capital flight. The PBoC (China’s Central Bank) looks to be shoring up Yuan liquidity in their money markets as the Fed has done but repo liquidity injections can signify risk concerns. Investors should listen. August puts make sense. FXI 2m IV is in its 69th percentile while EWH is in its 72nd percentile (both are 20% cheap to forecast). 2m Skew is fair for both for both underlying’s signifying investors aren’t really sure yet about market direction.