Time to Hedge?
Featuring Michael Purves
Published on: May 22nd, 2019 • Duration: 17 minutesMichael Purves, chief global strategist at Weeden & Co., walks through the recent price action in the stock market and explains why hedging might be a good idea right now. He examines the current headwinds facing the market, discusses several potential hedging vehicles, and considers risks to his thesis, in this interview with Jake Merl. Filmed on May 21, 2019.
JAKE MERL: Welcome to Trade Ideas. I'm Jake Merl, sitting down with Michael Purves, chief global strategist at Weeden. Michael, it's great to have you back on the show.
MICHAEL PURVES: Well, thanks for having me.
JAKE MERL: So, we're trading a couple percent below all-time highs. It's been a bumpy ride these past few weeks. Are you still bullish given what's going on? Or are you starting to get cautious here?
MICHAEL PURVES: I'd say right now I think risk reward is setting up not for the bulls. I think there's a strong case to be made that we'll just wobble around here, consolidate at these levels for some time. I struggled to find out how we're going to get another two, 300 points higher in the S&P 500 even if we get some nice resolution on trade, right? In other words, if we were having this discussion four weeks ago, I'd be making the same argument. So much the good is priced in right now. The Powell put has been well understood. And frankly, right now, if you look at the Fed dots, the Fed still has a hike in in 2020. Consider that if Powell maintains the course and doesn't do anything, doesn't alter anything and maybe even takes a 2020 hike out, there's still a huge gap between where that is in the markets are. So, that's a potential volatility catalyst, right?
And so, I do think there actually is some downside risk here, right now. If you go back to what's- early October, volatility started, the S&P broke its 200-Day Moving Average, we came back up above that with this year to date risk on. Having said that, we veered up really aggressively, right? Most of the times when you break an important working support level that's been established over a number of years, you like come up, and then you go back and retest a little bit. And so, the fact that we never came back down and put in a higher low from the December low, to me, makes it a little- the markets structure's a little bit more fragile.
And then let's zoom out for a second and talk about what started this recent bout of volatility two and a half weeks ago was really trade. And I think it's important to recognize that well, we don't know what Trump is going to tweet. We also don't know the Chinese reaction function, right? It gets a little bit more complex- the Chinese reaction function every day, it seems like. But I think it's important to recognize that Trump's hand has- with respect to pursuing a substantial renegotiation with China. And remember, on the State of the Union, he talked about look, he wants structural reform. You don't get structural reform in a couple of meetings and conference calls. No, that is a long-term process.
And look, let's face it, the US and the China are the two most important economies in the world. And they have a very intricate complex relationship, right, with different political systems. So, how that plays out is going to be very important and very interesting. But right now, you have to ask yourself, can Trump afford a 10% correction in the market 18 months ahead of the 2020 election? Can he afford a VIX hover in the mid-20s or the mid- 30s or even the 40s for a while? Sure, why not? Why not have some bloodletting in the market right now if you're Trump and have the market dip get bought more robustly into 2020, which is really when he needs that, right?
Let's also consider that his approval rating since he started the trade initiative about 12 months ago, they've been really remarkably stable. They dipped after McCain and then came back up, but they've been very, very stable. And actually, just very recently, they've been ticking up higher. And another really key facet of this discussion is that back in October, right, when he started putting his foot on the gas on this trade discussion into the midterms, I think it caught the market off-guard a little bit, because I think the market probably could say, hey, look, Trump, we get it, you want to do this stuff, but you're going to tidy it up before the midterms, right? And he didn't he pushed into the midterms, which is I think part of the reason why Q4 got so interesting and so volatile.
But we also today, what's very different today for Trump is that he can leverage the Powell put. He could not do that back in Q4. The Powell put is clearly established right now. And he can leverage that. That's a tool, that's an asset that Trump can leverage. And like any real estate developer, he's going to want to leverage an asset, right?
Meanwhile, he's got a backdrop of inflation light growth, right? Which is really, really good for him. And he can afford to- can he afford some market volatility as the market was pushing to fresh highs and all that? Again, over the last couple of weeks, we've had some jostling around. And then I think this is going to be not resolved anytime in the next week or two. I think this is going to persist for at least through the balance of the quarter. And I think you have to be prepared that way.
JAKE MERL: So, besides the trade war, what other headwinds are you looking at right now?
MICHAEL PURVES: Well, I would say this, look, I think the US story has been really very strong, right? Our outperformance stories is very, very clear relative to China, relative to Europe, relative to Japan. I think that's also well-understood by the markets, you can see that reflected in assets like the dollar and so forth. Interestingly, if you look at like the Citibank Economic Surprise Index, right? That has been a negative territory for most of this year. And over the last nine months, it's been making a series of lower highs and lower lows, right? In fact, it's actually doing much worse than many of the Citi Economic Surprise Indices for Europe or China, which is really interesting.
So, there's a little bit of maybe catch up here, right, with the rest of the world weakness in the US. Let's not forget that nearly 45% of the S&P revenues are sourced overseas. And you look through some of the industrial companies like Deere, for example, that just came the other day. It really wasn't that great, right? So, that's another thing that I'm concerned about.
I think it's also, look, at the semiconductor index, the socks or the SMH ETF, right? Those preceded the market volatility in Q4, really starting in August of last summer. The earnings outlook was not strong for semis last summer. The earnings downgrades were coming. The price action was getting very choppy. And here we are, sure enough, the price action is not good. And that's signaling not just some supply chain issues that's going to be coming out of trade. But I think it's also simply that as a global growth indicator, there's some real concerns there. And so, that's another thing that I'm concerned here.
So, the S&P, one thing we've learned is that against the backdrop of low and stable inflation, low and stable interest rates and a Fed that's inherently dovish, before hawkish, and has the benefit of structural disinflation to help manage the upside inflation dynamic. The S&P is pretty darn resilient, right? It just is. Having said that, could we get down another 200, 300 points on the S&P 500? Perhaps suddenly, absolutely.
JAKE MERL: So, would you be looking to go short here? Or how would you recommend playing the current environment?
MICHAEL PURVES: Right. Well, I think it's interesting. One of the stories about this risk on rally is this massive polarization within side of the S&P 500. And let me try to explain that. So, if you looked at the ratio of financials to, say tech stocks, right- or for that matter, to the S&P 500, whether it's on a valuation basis, or simply on a price basis, right? You went to multi- decade extremes, right? Tech was clearly leading the way higher. Similarly, if you looked at utilities, utilities were extraordinarily overbought. Why? Because people were playing defense coming out of the scary December and two, because the bond yields kept going lower longer, right? And they just seem to be like, cemented into this, like we're not going above 2.5% on the 10-year basis.
But nonetheless, there was a lot of polarization, right? Tech stocks went to all-time highs, record valuations there. And I think that's a lot of opportunity. So, the hedging trade I really liked, I put out on April 8 was to buy XLK put spreads, and not the Q's, by the way, because the Q's had Fang in it. And what's really interesting- this is an important distinction, which is that the Fang valuation- year and a half ago, we're having this discussion, Fang valuation could get very high. It really ever since these started with the Facebook hearings a year ago in front of Congress, when Zuckerberg had these discussions, and of course, some of the earnings stories haven't been pristine, like Google, for example.
But the Fang valuation, if you look at a market cap weighted Fang index, it never really got that expensive there. So, the reason why I like the XLK ETF for the puts was because it didn't have the Fang. It had this extraordinarily high valuation from other stocks, for example, Microsoft and Apple and also stocks that a lot of which were heavily exposed to the globally integrated supply chain story that is vulnerable in the context of these trade discussions. So, I put out those. The put spread, it paid, I took profits.
I still would say this, I still like the XLK as a short. The implied volatility was also very low three weeks ago. It's a lot less low now, right? If you measure it relative to for example, the VIX there. So, I think at the very least, you'd want to be in spread form, you could also look at more complicated structures going one by two on the put side on the XLK or just simply short the XLK.
But there's another way to approach this as well, and I think this is maybe just part of a broader hedging tactic strategy. When you get into environments, particularly coming out of this highly polarized world where the ones that ran the farthest are going to fall the first, as we saw, whereas bank stocks probably wouldn't have been as good a short. But it's important when you're buying puts for market hedges to be really cognizant of what you're- not just blindly say, oh, well, here's a broad base index.
Like, for example, the Russell 2000 right now did not participate aggressively in this risk on rally year to date, right? If you look at the ratio of the Russell 2000 to the S&P 500, it's at multi-year lows. And so, I would not recommend, for example, IWM puts. Therefore, generic market hedging, particularly given that the Russell's more insulated from the trade discussions than the S&P 500 and certainly, the NDX would be.
But I think if you want to look at another way of complementing your hedging portfolio, is to look at the HYG puts, for example, or simply a HYG common on the short side. Look, if trade is resolved tomorrow and risk appetite is strong, I would say the fundamentals within high yield are reasonably decent right now. I'm not making a call that credit quality is going to tragically weaken anytime soon, right?
But what you saw in October and November, December is that equities took all the vol first. And then eventually, if that vol persisted, it would just be a matter of time to get caught up with other assets like high yield. And so, the implied vols on the HYG back in December blew out. The share price plummeted. And those puts really worked well. I'm not indicting HYG. What I'm saying is, is that if risk appetite gets uglier with all these growing trade tensions, and right now, you want to see where the implied vol is cheap, what asset hasn't really moved that much yet and look at that, particularly if the VIX is back in the high teens or 20s. As we're speaking, it's 15, and so forth.
But if we're having this discussion a week ago, when the VIX was up in the 20s, the risk reward for buying puts on equities then is simply not as compelling. So, you have to be very discerning about where you're going to be buying your hedges.
JAKE MERL: So, is there a specific contract you like? Or do you just generally recommend buying put spreads here?
MICHAEL PURVES: Yeah. I think the price moves around so quickly, but I think about certainly for HYG, look at probably puts outright in July, something like that. I wouldn't do June because it's a little too close, you're going to need some time here. You don't want your state indicator to eat away at your put option premium too quickly there. And then if let's say, HYG dips a little bit but doesn't really get the move, you might want to think about rolling that out if that July expiry is coming really closely. Generally, I like to buy a little bit out of the money for these types of exercises. You save a little bit of money relative to the out of the money, but you don't want to be too far out of the money either. JAKE MERL: So, what would you say is the biggest risk to this trade? MICHAEL PURVES: To the HYG puts, simply that the S&P meanders around, risk appetite is generally there. And the trade war rhetoric, even if it escalates, doesn't get felt by the markets if the markets big risk appetite becomes immune to the trade rhetoric. But look, I think it's important to step back and realize that some in the course of a year, particularly after a vicious risk on rally off those December lows, it's normal to have some volatility along the way, right?
So, between now and the end of the year, it's not just going to be a straight line higher. It's going to be timing those things is trickier. But it's important to recognize also the valuation on the S&P 500. And late December was very compelling. Real earnings yields we're very rich, the forward PE was looking really, really must-buy. Today, the PEs expanded two and a half basis points, right? So, all of a sudden, we're now in the top third of all PE readings for the S&P 500 going back eight years.
I'm not saying that the market can't go higher here with a higher PE. What I'm saying here is that the probability of getting more volatility at a higher PE is simply higher because that value floor just isn't there the way it was in December.
JAKE MERL: Well, Michael, that was great. Thanks so much for joining us.
MICHAEL PURVES: You bet.
JAKE MERL: So, Michael is getting nervous on the stock market. He specifically suggests shorting the technology sector SPDR ETF ticker symbol XLK. He also suggests buying slightly out of the money July puts on the iShares high yield corporate bond ETF ticker symbol HYG.
That was Michael Purves of Weeden. And for Real Vision, I'm Jake Merl.