Options insurance. Hedging with Treasuries. Using sentiment to pick a bottom. The things that have lessened the pain of past equity selloffs are coming up short this time around.
Case in point this week, with its forceful pivot from multimonth lows. Sudden relief rallies have become the bane of would-be hedgers, who are paying dearly for bearish options in 2022 that often fail to deliver gains. A straightforward protection strategy of owning 5% out-of-the-money puts on the S&P 500 has lost almost as much as the index itself this year, thanks to the contour of the decline.
A chunk of the S&P 500’s loss was rolled back over the holiday-shortened week, with the index surging more than 6% as a report showed inflation expectations eased. Stocks are still stuck in a bear market after falling as much as 24% since January, weighed down by concern interest-rate hikes by the Federal Reserve will thrust the economy into a recession.
The year’s drubbing has left bulls bruised, but if picking a bottom when pessimism crests is your idea of sound trading, you’ve had your head handed to you repeatedly in 2022. Ultra-bearish readings in sentiment that used to be reliable buy signals are now luring people in for additional hammering. Also failing have been most attempts to seek protection in government bonds. Once a harbor against turmoil, Treasuries have served no such purpose of late.
“We’re really in unusual and unique times,” John Flahive, head of fixed income investments at BNY Mellon Wealth Management, said by phone. “One of the rationales for the breakdown of what traditionally would’ve been buffers is that interest rates were so manipulated at historical lows, and the adjustment period and the friction created from that change is what we’ve experienced here in the first half.”
Stocks rose for a second time in 12 weeks, with the S&P 500 posting the second-best advance of the year. Beneath the surface lingers heightened angst over the growth outlook, as economically sensitive shares like commodity producers and industrials performed the worst.
An MSCI index tracking cyclical stocks is on track for a seventh straight month of trailing one that follows defensive plays like consumer staples. That would be the longest losing streak on record.
Even with the S&P 500 off 18% this year, a gauge called the Cboe S&P 500 5% Put Protection Index, tracking a strategy that holds a long position on the index while buying monthly 5% out-of-the-money puts as a hedge, is nursing a loss that is almost identical. That’s a stark contrast from the March 2020 crash, when the trade returned 2.2%.
The tactic is failing because the selloff is so often interrupted by rallies like this week’s. Friday marked the 12th time that the S&P 500 rose at least 2% in a single session. At this rate, 2022 is on course for the third-highest annual number of big up days since the 1930s.
Such counter-trend rallies have slowed the pace of the overall swoon, a setup that makes it more difficult to reap profits on out-of-money puts than during a cascading rout where the bets pay off right away.
“Think of it as an insurance policy with a deductible,” said Goldman Sachs Group Inc. strategist Rocky Fishman. “Every month your house gets damaged but only a moderate amount so you can’t claim much back from your insurance company. And you’re paying for insurance the whole time.”
With losses persisting during the first half, short sellers are reloading, and retail investors -- some of the last bulls at the party -- are finally capitulating. Sentiment has worsened to levels not seen in years.
In the past, that degree of pessimism would be viewed as a contrarian buy signal. Now, going against the herd has turned dangerous when the Fed is no longer the market’s ally, according to Chris Verrone, head of technical analysis at Strategas Securities.
Studying Investors Intelligence survey of newsletter writers and market performance since 2010, Verrone found that bearishness reached peaks in the polls six times before this year, all happening around market bottoms and foreshadowing equity gains in coming months.
This go around, bears outnumbered bulls for the first time 16 weeks ago, and stocks kept falling.
“Is it really bearish sentiment that has some contrarian causation to strong forward S&P returns, or have past episodes of extreme sentiment been coincident with a liquidity response from the Fed? The truth likely lies somewhere in between,” Verrone said. “Extreme sentiment conditions without the benefit of a Fed put are less meaningful.”
Indeed, Fed Chair Jerome Powell reiterated this week that his commitment to curbing inflation “unconditional.” While traders recently pared back their expectations for rate hikes amid recession fears, the damage from a hawkish Fed is already done, leaving investors almost nowhere to hide.
That’s caused distress for those who have stuck with another strategy in the playbook from past bear markets by parking money in government bonds. Take the iShares 20+ Year Treasury Bond ETF (ticker TLT), for instance. During the 2020 equity crash and the 2008-2009 financial crisis, the fund delivered returns of 14% and 18%, respectively. This year, the fund is down 24%, worse than the S&P 500.
Blame the bond collapse on red-hot inflation that has forced the Fed to toughen its hawkish stance, according to Emily Roland, co-chief investment strategist at John Hancock Investment Management.
“The biggest challenge that we’re facing today is that Fed support is not there,” Roland said. “There’s a lot of bad news on the bond front but the good news is that a lot of it, in our view, has been priced into the bond market.”
“We think that bonds will start to do their job as a diversifier against stocks,” she added. “We’re hopeful on that front but certainly acknowledge that it hasn’t worked the way that normal relationship tends to work.”
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