A simple, low-cost protection trade for those doubting this bull market

Published Mon, Jan 22 202410:48 AM EST

For an agonizing month, the S & P 500 toyed with the prior all-time highs of January 2022 before finally breaking through to new all-time highs on Friday. History provides several reasons to believe this rally has legs, but a closer examination of the data also provides some important reasons to doubt it. Fortunately, the options market may provide a solution for investors. The most active options in all of the Magnificent 7 stocks, those that propelled the index in 2023 were, in every case, upside calls that expire this coming Friday. The most common call was that investors would begin to rotate out of these stocks in 2024 and that investors would rotate, perhaps to value stocks, or to healthcare which notably underperformed in 2023. Yet here we are, reviewing the biggest trading day of the year so far, and AMD was the best-performing stock in the S & P. Nvidia was 12th. The worst-performing stocks? Molina Healthcare, Centene Corp (a managed care company), Humana, United Health, Enphase Energy to name a few. So will the rotation take place? Or will 2024 be a repeat of 2023? Or is danger lurking? The Good News: Virtually every investment outline of historical investment performance will be accompanied by the disclaimer that "past performance is no guarantee of future results". SEC Rule 156 when guiding about potentially misleading and therefore prohibited statements highlights several examples of any that imply good results are more likely as a result of good results in the past. Some are touting that good years often follow good years. That election years are generally good for stocks. The truth is this data is relatively sparse. What is true is that the S & P 500 rises over time. It is higher more often than it is lower, and there are good reasons for this. In general, the economy grows. It's therefore reasonable to also assume that the earnings of the constituent companies in an index such as the S & P 500 will also grow over time. Market Cap weighted indices, such as the S & P 500 represent the largest and generally most successful publicly traded companies. As companies in the index underperform others, their respective weight drops, and if they underperform significantly enough they are removed from the index and replaced by companies that are growing. This survivorship bias and the fact that a cap-weighted index places more weight on the most successful businesses means that the collective earnings historically grow at a pace faster than the economy overall. Since 1990 S & P earnings have grown more than eightfold, or approximately 7% year-over-year, considerably higher than the annual 4.8% nominal GDP growth the US economy has averaged over the same period. Supply and demand for stocks. Investors generally invest systematically in equities whether via 401k plans, or private and public pension plans. For a host of reasons including mergers, private equity, and private companies, particularly startups, staying private for longer as venture capital expanded, systematic investors have been chasing an ever smaller universe of stocks, and those stocks represent companies that are as large or larger on a relative basis than they have been historically. Whether one is concerned about the size and influence of these goliaths it is undeniable that scale is often a benefit for a business, and these businesses are benefiting from that scale. The margins at the largest companies, such as Apple and Microsoft are astonishing. Massive revenues combined with astonishing margins create record profits. So large in fact that just those two companies combined are expected to generate nearly 1% of GDP in 2025, over 200 Billion USD. As an aside, they also probably represent more than 8% of all US corporate income tax revenues for FY2023. I could go on, but in short, the S & P 500 captures the most successful publicly traded companies which generally grow faster than the economy. The Bad news: Interest rates bottomed in 2020. For nearly 40 years, from the early 1980s to 2020, rates fell. In the first couple decades for good reason. The inflationary beast that roared to life in the 1970s finally was put down with an aggressively hawkish monetary policy. Although it's hard to imagine now that was followed in the 1990s by reasonable, by government standards anyway, fiscal spending by the Congress. Few may remember how serious they were about it, attempting to pass a "balanced budget amendment" to the Constitution. In any event, the combination of these with increased globalization held inflation to a reasonable level for an extended period, and rates fell to levels unseen since the 1950s. Then came the Great Financial Crisis starting in late 2007. In a free market, the inflated housing prices would have collapsed and a very severe recession would have resulted. Policymakers elected to blow some air into the rapidly deflating bubble with aggressive fiscal and monetary policy, pushed rates below a natural rate, and kept them there. The "balanced budget" (in quotes because it only addressed the deficit as measured by the government's cash accounting, not unfunded liabilities associated with entitlements) of the late 1990s became a faint memory as fiscal deficits exploded. The reason this is bad is that eventually, this allowed the inflation genie out of the bottle. Add to this global strife and concerns about China, and companies are now incorporating geopolitical risk into their calculus of the cheapest place to do business. This slows, or even reverses, some of the deflationary impact of globalization. Many benefited from low-interest rates. Good companies could borrow cheap money to expand, mediocre companies would see some potential margin improvement from the lower cost of capital even if they weren't growing. Bad companies could roll over their debt at ever lower rates in a cycle of extend and pretend. Default rates fell. Individuals could buy more stuff and the prices of their assets, such as houses, stocks, and bonds expanded too, so they felt wealthier as well. The biggest borrower, the U.S. government, went on the biggest bender of all, and government spending, even if the return on government dollars isn't quite as good as that in the private sector, was so enormous that it had a material impact on the economy. So what's bad about all that? The reversal in rates has the opposite impact. Pull out government deficit spending and GDP growth isn't as good as the headline number suggests. Higher rates mean higher defaults for less creditworthy buyers whether corporations or individuals. Interest rate expense for the US government is exploding, and the deficit, which would normally be expected to contract as the economy recovers isn't. Either corrective step, reducing spending or increasing taxes, both of which are likely advisable, are contractionary. You get the idea. The Ugly truth: Stocks don't typically rise from elevated valuations as rates rise and the economy slows. There will be winners to be sure, and those winners — at least the publicly traded ones — will be in the S & P 500, but that might not be enough. What to do: Options prices generally fall as markets rise and worry fades. That's true today. Notice that a January 2025 SPDR S & P 500 Trust (SPY) $460 strike put costs just over $16 per contract. Just 3.3% of the current level of the index for protection expires a year from now. The trade: Bought Jan 2025 $460 put for $16 The fact is the market rises more often than not in election years, following up years, following down years, in general. If this isn't one of them though, a little protection might go a long way. DISCLOSURES: THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL'S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. Click here for the full disclaimer.