September 2017 – Monthly Commentary
Signs of excess abound in the capital markets as the ongoing emergency monetary policy supports frothiness and exuberance at every turn. Last month, billionaire Warren Buffett commented that he wouldn’t be surprised if the Dow Jones Industrial Index, currently valued at 22,600, climbed to 1,000,000 in the next one hundred years. In making that audacious prediction, Mr. Buffett seemed to be showing unbridled confidence in the stock market. However, solving for the average return, a mere 4% compounded annually would take the index to 1,000,000 in 2117. Since 1928, the average annual return for the index was has been approximately 11.4%, or nearly three times that expected by Buffet. To measure the variation around that average return, statisticians look to the standard deviation, which for the same period was approximately 19.7%. Sparing the reader the calculations and explanations, that standard deviation implies that an investor can expect, with near certainty, that the return of the Dow Jones average will be between and -47% and 70%. That’s an enormous range, but reflective of what has been witnessed since 1928. The worst year was -43% in 1931 and the best year was 52% in 1954.
At this point the reader may be wondering why an investment firm specializing in fixed income cares about the risk/return profile of stocks. The short answer is that stock prices are one of the macro factors that impact interest rates. What prompted our thinking was the collapse of implied volatility imbedded in S&P500 option prices, often referred to as the VIX, or as the media likes to call it, the fear index. On September 21st, the day after the FOMC meeting, the implied volatility on S&P 500 options touched 6%, one of the lowest levels ever witnessed. To put that into context, let’s assumes that for the next for the next 100 years the average expected return of the S&P 500 will be 11.4% as it was for the last 100. If so, that 6% implied volatility is indirectly saying that you can expect the stock market to generate between -7% and 29% with near certainty. Of course, the options we’re talking about expire in two weeks, not 100 years. But the concept is the same and illustrates the ridiculous degree of complacency that’s crept into the capital markets.
The irony is that the media had been abuzz in September with continued nuclear saber-rattling out of North Korea, the catastrophic results of two category 5 hurricanes, the worst earthquake in Mexico in over 30 years, and hawkish language from the Federal Reserve. To further drive home the irrationality of the capital markets on that same September day that implied volatility bottomed, pundits were pointing to the yield differential between the 5-year and 30-year Treasury notes as indicating that a recession is looming. If a recession is looming, stock prices should be a whole lot lower, and implied option volatility a whole lot higher. Recall that in a recession profits recede from their previous high and the price/earnings ratio of those earnings contracts, taking stock prices lower.
We do not share the view that the U.S. is at risk of recession, but we are of the opinion that stock prices are overvalued, especially if interest rates rise, which seems likely, albeit at a very slow pace. With that opinion and the exceptionally low cost of option protection, now may be a good time to hedge one’s equity portfolio.