How many times have we heard the long-standing trading adage, “Don’t fight the Fed!” when discussing portfolio positioning in the stock market? When studying equity markets across time, one notices that the market heads to higher valuations when our Federal Reserve is in a process of reducing interest rates or keeping them low on a relative basis as this encourages “animal spirits” to hunt for returns on risk that can only be achieved in areas like equity markets. This adage, if followed, provided phenomenal returns in the bull market run that began in March 2009 and ran through the early months of 2015. As we fast forward to February 2016, we see a very different scenario coming to play in the equity market as the Fed began a tightening cycle in December 2015 by raising rates ¼ point – the first rate rise in almost a decade! The global equity markets have sold off strongly in these first six weeks of 2016. Let’s examine why equity markets have become more volatile and bearish in their nature as it relates to interest rate policy.
The purpose of “easy” monetary policy is to encourage banks to lend and consumers to borrow. In past business cycles, this has proven to be effective policy and enabled the U.S. economy to grow its way out of recessionary cycles. The recovery from our 2008 recession has been different. Consumers have been tepid regarding their spending habits. Companies have forgone investment for the long term favoring hoarding of cash or taking on debt of their own – at these record low levels of interest charges – to finance share buybacks in an effort to support their equity valuations. At the same time, we have seen a rally in the dollar relative to other worldwide currencies on expectations of rate hikes and growth. This has been cited recently as a headwind to earnings for multinational corporations. It stands to reason, then, that given these dynamics, we will continue to see volatility in our equity markets for some time to come.
The following are a number of factors investors are watching carefully to determine when it might be “safe’ to enter the market again including:
- Additional clarity from the Fed regarding the path of additional rate hikes
- Economic data from China shows signs of stabilization or improvement
- Stabilization in the oil market
- A return of a healthy IPO ( initial public offering) market
- Leadership in companies outside of the “FANG” stocks – Facebook, Amazon, Netflix and Google parent Alphabet
As we wait to determine if the market has put in a sustainable bottom, should we simply sit in cash and miss potential opportunity? Those of us who understand options use these periods of volatility as opportune moments to generate trades that can provide exceptional profitability in multiple trend scenarios. We also utilize options to hedge the risk we have in our portfolios against a continuation of bearish price action. One trade that has performed particularly well during this selloff is the collar trade which involves combining share ownership with options to hedge downside risk and allow profitability