#Market Strategy — 27.08.2016


Prashant Bhayani

What to do now with US equity exposure ahead of coming market events?

When I speak to market participants and clients I keep hearing about the extreme volatility of markets, and that uncertainty is very high, and a long list of market worries. While I sympathize, I have never worked in a market without "perceived" uncertainty. 

However, year-to-date, outside the beginning of the year, this year has seen low volatility relative to history across US equities (see Chart 1). In addition, the S&P 500 has reached our mid-single digit target, as well, after drawdowns earlier in February when we took up equity weightings. That was definitely not the consensus view at that time as the S&P 500 index approached 1800 when most thought it would challenge 1650.

What a different market now, as the VIX, a measure of S&P 500 volatility, is running 30% below its average of the past year. The S&P 500 is up 7% year-to-date and nearly 22% above its lows in February. Furthermore, in respect of a supposed “Black Swan” event, Brexit, volatility lasted similar to the length of a heatwave during an English summer— three days and then a shower!

Chart 1: VIX Chart since 2012

Source: CTFC, S&P  Dow Jones Indices, Bloomberg, BNP Paribas Wealth Management, as of 19 August 2016

In addition, fund manager cash levels before Brexit, were higher than during the financial crisis. Hence, most fund mangers have been caught wrong footed and forced to reposition back into the market. Markets often climb a wall of worry and this year is another great example of that. However, positioning now is not as bearish (see Chart 2). Hence, the inflows driven by too cautious positioning may not be there to push the market higher in the very short-term outside better fundamentals which have also improved recently.

Chart 2: US Short Interest as a Percentage of Float is at a 12-Month Low

Source: BofAML US Equity & Quant Strategy, Bloomberg as of 23 August 2016

Hence, while we are neutral, we are NOT underweight US equities and still overweight sectors such as healthcare, technology, and banks.  However, this could be an opportune time, given low volatilities, for clients who are positioned long US equities to consider ways to hedge via equity puts or structures if they would like to minimize any potential drawdown.

The cost is historically low given the low level of the VIX. Volatility may not stay at this level for long. In addition, record levels of investors betting on volatility remain low (see Chart 3).

Chart 3: Speculative Positioning on VIX Recently Hit Record Short Levels

Source: BofAML US Equity & Quant Strategy, CFTC, Bloomberg, as of 23 August 2016

Moreover, historically September is generally a poorer month for equities (see Chart 4).

Chart 4: September is Seasonally the Weakest Month of the Year

Source: BofAML US Equity & Quant Strategy, S&P, Bloomberg, as of 23 August 2016. Note: Based on S&P 500 price returns since 1928

Furthermore, we also have a number of events in the coming months: (1) Jackson Hole and Fed rate rise expectations, (2) Italian elections, and (3) US elections as well. Policy uncertainty and the VIX generally rise starting three months before the US presidential elections and then declines after the elections in November (see Chart 5).

Tactically portfolios with large equity weightings could consider hedging while maintaining their overall equity portfolio allocation, which is important, as staying invested is the best long-term way of remaining and becoming more wealthy. Investors have been net sellers of equities since 2009 to their detriment, as selling out completely out of their equity allocation has been a massive opportunity cost thus far, and we must distinguish between tactical positioning while maintaining core equity allocation. Don't let the tail wag the dog!

What to do given record low government bond yields and record high US equities?

Finally, we must broaden our tool set and utilize other asset classes outside bonds and equities, in this case, being hedge funds, in order to benefit from their lower correlation to the traditional assets, ability to short the market, and minimizing drawdown risk can generate superior risk-adjusted returns and diversify client exposure as well.

Chart 5: Policy Uncertainty and the VIX Usually Rise Ahead Of Elections

Historical average and current levels of US Policy Uncertainty Index (1985-present) and VIX (1990-present) by month relative to Presidential Election (month 0)

Source: Haver Analytics/PolicyUncertainty.com, BofA Merrill Lynch US Equity & US Quant Strategy, as of 23 August 2016