ZEGA Response to Market Volatility
By Derek Moore
While the S&P 500 Index and Nasdaq 100 were both already in correction territory, the geopolitical news overnight has put more pressure on markets.
Of course the news unfortunately carries with it a cost outside of markets and we are hopeful the human cost is not as great as feared. We wanted to share our thoughts on the market reaction and will include what we’ve been hearing and reading.
We also wanted to give some brief general commentary on our main strategies.
Market Price Discovery and Volatility
As a firm that watches volatility constantly, we are attuned to the interplay between realized and implied levels effecting markets.
During market events like this, typically we do see some price dislocation as everyone digests the news and positioning gets reset. As expected, we saw quotes widen (spread between the bid and ask) at the market open. This process of price discovery needs to sort itself out.
We will note that while markets were lower year to date, thus far we had seen a more orderly downturn unlike what we witnessed in February of 2020.
ZEGA Strategies
Buy and Hedge Retirement
For your clients in our Buy and Hedge Retirement, you are already hedged.
As markets have come down you are experiencing expected drawdown that is less than the market. We looked to hold 12-month losses to around the first 8% - 10% down on the equity positions tied to the S&P 500 Index. At the same time, while the short duration high yield has sold off year to date, our hedges have provided an effective cushion.
ZEGA Buffered Indexed Growth (ZBIG)
For clients in any of our ZEGA Buffered Indexed Growth or ZBIG portfolios, to varying degrees you are experience a give back of profits as markets and high yield have come off the previous highs.
The initial buffers are intact as designed to limit losses. We do not reset the buffer upon every move higher as that would be cost prohibitive. We point out that the main risk in those portfolios is short duration high yield.
It has been constructive that high yield in general has not moved down as much with markets and bankruptcies remain at decade lows.
High Probability Options Strategy (HiPOS)
For clients in our HiPOS short volatility strategies, this type of environment does pressure existing positions.
Typically, prices get wider and implied volatility jumps. This causes the prices of our spreads we’ve sold to increase. As net sellers of volatility, we want the price of our spreads to go to zero by expiration date. Those of in our HiPOS Conservative strategy see current positions move into an unrealized loss.
We will put out a HiPOS update tomorrow but at this time, the existing positions are still sitting at a level that does not require any adjustments. More time passing and a reduction of the current volatility spike would ease positions back towards neutral to positive pricing.
Those in our HiPOS Aggressive model will continue to see ZEGA’s traders keep expirations very short as we look to capitalize on the increased volatility.
Commodities
While both oil and other commodities like wheat were already trending higher before this morning, both spiked on the news.
Russia is the worlds top producer of wheat and third for oil production. Commodities also have been a favorite inflation play. We’ve noted in the past that many had already experienced quite a bull run over the past year plus.
We note this as many commodities also are part of the Consumer Price Index (CPI) inflation gauge
This potentially may put additional upward pressure on inflation in the near term. A CNN Business article made some projections on how additive to inflation oil moving above 100 might be.
Inflation and The Fed
Our last point dove tails right into the inflation conversation and expectations of interest rate moves at the March meeting and beyond.
According to the CME Fed Probability Tool, overnight the probability of the Fed raising by a full 50 basis points dropped from 33.7% down to only 9.5%. Meaning, less of a chance they raise more than a quarter point. To be clear, the Fed Funds Futures still point to roughly 100% chance they raise at least 25 basis points.
Mohamed El-Erian appeared on CNBC this morning to talk about the challenge the Fed has in balancing rate hikes against the backdrop of a geopolitical event.
You can check out the clip below, but essentially his opinion was this reduces the number of times the Fed will raise this year. He also mentioned in the clip the idea that The Fed will have to tolerate higher inflation.
Historical Corrections
Source: Schwab Market Perspectives
Schwab’s article (linked above) provided some great insight into historical drawdowns.
Corrections are defined as a drawdown at least 10% from a prior high while bear markets need prices to close 20% below prior highs. As the graph outlines, since 1974, only 5 out of 24 corrections went on to bear market territory. As we always talk about, we don’t pick market direction or trade based on opinions.
It’s natural for investors to become sensitive to higher volatility and markets.
But a good reminder is that markets do suffer drawdowns more often than we’ve experienced of late. Often markets resolve themselves eventually to higher levers. Below we can see a graph showing the intra-year declines vs. the final year returns in the S&P 500 Index.
Source: JP Morgan Guide to the Markets
It is worth noting that if you watched CNBC over the last few years, you probably heard prognosticators talk about how high forward PE ratios were.
With the market retracement year to date, the forward PE on the S&P 500 may move below 19. At the same time year to date earnings are up 2.5%. In other words, the declines have come from a re-rating of what investors are willing to pay against earnings.
Russia and Ukraine Impact on S&P Companies Revenues
Finally, we’ve had a few questions on whether there is a direct impact on companies within the S&P 500 Index.
FactSet noted in a recent piece that even before today’s news, companies mentioning Russian in their earnings calls was up much more than in the past.
They also noted a sample of the percentage of revenue some companies received from the region.
The highest was Phillip Morris with around 8%. While others like Pepsi and McDonalds were a little more than 4%. With earnings season pretty much done for Q4, as Q1 starts to roll out in April we may have a better sense, if any, impacts.
Are There Comparable Market Events?
Source: Investopedia
I did a quick Google search and found this piece on Investopedia.
Yes, I probably broke my own rule about not using Investopedia, but the graph was nice enough that I thought everyone would appreciate it. Above you’ll see some events going back to 1941, the one-day drawdown, total drawdown, and calendar days to bottom and recovery.
Each one of those is different in its own way, but I’ve fielded at least a few questions on historical precedents.
As always reach out to a member of the ZEGA team if you have further questions.
We wanted to provide a few points to help digest the current market cycle. At times like this we think its important to take a step back.