FAS Monthly Market Update August 2020

FAS Monthly Market Update August 2020

Posted By FAS Team

 

Economic Conditions

U.S. GDP decreased at an annual rate of 31.7% in the second quarter of 2020 according to the second estimate released by the U.S. Department of Commerce.  Though not as bad as initially estimated from the advance estimate in July, Q2 was still the steepest quarterly decline in history.

Unemployment claims have been gradually decreasing since hitting their highest levels since 1960 earlier this spring.  Initial unemployment claims fell below 1 million in August for the first time since they peaked at over 6 million in late March.  Since March employers have replaced about half of the 22 million jobs displaced, although the pace slowed in late summer and layoffs remain relatively persistent.  While many speculate how many jobs lost during the pandemic will be considered permanent, several industries such as auto-manufacturing, warehouses and call centers are experiencing increased demand for workers.

While unemployment claims continue to fall and as more and more consumers begin to venture out of the house, GDP growth for the third quarter still remains somewhat of a mystery as the estimates range from as low as 15% to as high as over 30%.  The Atlanta Fed’s GDPNow forecast estimates Q3 GDP growth to reach 32% while the NY Fed’s Nowcast Report is estimating 15.6% – a relatively large discrepancy between the two live estimate models compared to their historical differences.

Market Conditions

Markets continued their summer rally throughout the month of August and into early September.  As we’ve discussed in months past, much of the rally has been driven by a handful of names – specifically in large cap and more specifically in tech which took the brunt of the losses after reaching new highs earlier this month.  Since September 2 highs, the S&P 500 growth index is down over 10% while the S&P 500 value is down 3.27%.  The S&P 500 as a whole is down 7.7% during the same time frame.

Not only has value performed better during this most recent pullback, but small and mid caps have outperformed their large cap counterparts as well.  The S&P mid cap and small cap indexes are down 5.68% and 5.34% since September highs.  While two weeks is hardly enough time to identify a trend, it does give credence to the fact that we do not chase returns and that maintaining a balanced allocation among several asset classes and sectors remains vital in protecting against volatility in the markets.  We discussed last month how large cap stocks were trading at more expensive levels relative to small caps.  While small caps didn’t rally into September, they did outperform by being down less than large caps over the last several weeks.  All stocks were (and arguably still are) toward the top ends of their valuations from a historical standpoint which may have been one reason for the pullback.  Again, this serves as a reminder that markets tend to be mean reverting which is why we don’t want to chase performance in expensive stocks.

Options and Volatility

It would be an understatement to say the moves we have seen in the markets in 2020 have been out of the ordinary.  In early spring we saw markets experience one of the deepest and quickest drops in history.  What followed was one of the largest and quickest recoveries in history.  What, at the time may have felt like a lifetime, now feels like a “small” blip on the chart even with the recent pullback we have seen since early September.  We have talked extensively about how the market is a leading indicator and it has appeared to be looking through 2020 and focusing on 2021 and beyond with regard to earnings and valuations, but that may not be the only factor responsible for this historic recovery.

In late 2019 Schwab and other custodians announced they would no longer be charging commissions on equity trades or options trades.  What ensued was almost a perfect storm of free trades, no sports, people stuck inside on their computers, and a bull market for tech stocks anticipated to benefit from working at home.  Retail investing took off, specifically in the options market.  Options trading can be utilized in numerous different ways such as hedging exposures, protecting potential losses, generating income, etc.  But they can also be used to lever returns, allowing risky investors to see outsized returns in short periods of time – or be completely wiped out in that same time frame.

An option is a contract that allows an investor the option, not the obligation, to purchase or sell a stock at a predetermined price (called  the strike price).  Without getting too much into the weeds we will just cover call options since they are the most straight forward.  If we assume an investor anticipates the price of stock ABC, currently trading at $100, to increase they might purchase a call option with a strike price of $105.  This means if the price rises above $105, they have the “option” to purchase that stock at $105 regardless of where the stock trades.  If stock ABC rises to $110, the contract is considered “in the money” and the owner exercises the contract by purchasing ABC at $105 and immediately selling for $110, pocketing a $5 profit minus the premium paid for the option.  This is different from purchasing the stock at $100 and waiting for it to rise to $110 because each options contract is an agreement to purchase 100 shares of the underlying stock.  Options offer a cheap way to lever up returns because as the price of the stock rises so does the value of that options contract, but by magnitudes greater than the rise in the stock.  Alternatively, options also have expiration dates which means if the stock does not rise above the strike by that date, the investor loses their premium – a total loss of capital.

Options activity has significantly accelerated in 2020.  According to Susquehanna Financial Group, the average size of all options trades is six options which is half the level it was two years ago.  Likewise, there has been continued increase in the number of single contract purchases which now account for 12% of all call option trading – up from 6.5% at the start of the year.  Both of these data sets tell us retail investors, with significantly less capital to invest than institutions and therefore purchasing less contracts, are flooding the markets with options buying.  Schwab has seen an increase in the number of options trades this year by 116%, but have seen the number of actual contracts increase by only 80%, indicating more investors are trading, but at lower volume.

So what does this mean for the markets?  When an option contract is purchased, the counterparty who is the seller of that contract only wants to take the premium charged for selling that contract to the investor.  Otherwise they are taking the other side of a bet and could potentially lose money.  In order to hedge their exposure to risk of the stock going up and having to pay the investor their profits, they will purchase the stock of which they sold the contract on.  If the price rises, they participate in the gain and continue to purchase more in order to adjust their hedge.  Likewise, if the stock falls, the value of the option contract will fall with it and they will sell the underlying stock to lighten their hedge.  The more options purchased on a stock or index, the more buying being done by the counterparties to hedge their risks causing markets to rise quickly as we have seen.  Similarly, as markets begin to fall and investors pour in to buy put options (the opposite of a call option which bets on a stock price falling), those same dealers are selling stock to hedge their positions against the put options, further exacerbating downturns.

Options are priced primarily through what is known as implied volatility which is the forecast of a likely movement in a stock price.  Traditionally, as a stock rises, its implied volatility will fall as investors assume the stock will not continue to rise at its current pace, and because of that options prices will tend to fall.  The two don’t typically move in tandem with one another.  However, that is exactly what we have seen in the last several months.  As stocks like Apple and Tesla continued to rise, not only were more and more people pouring into options for those stocks – they were continually paying more and more for those options, causing the implied volatility to rise.

This is not meant to scare anyone or to say the market is due for another major crash.  This is just something we have examined and can use to somewhat explain some of the volatility we have seen in recent weeks.  There are ways to utilize options in hedging strategies and to help protect losses or even generate additional income, but there is no way to get rich quick without the inherent risk that comes with it.  Buying short-dated call options in anticipation of a quick rise in price is no different than buying a stock in anticipation of it quickly rising – in fact it is worse because you can be completely wiped out with an options contract as opposed to having the benefit of holding onto a stock if its price were to fall.  Maybe now that football is back the gamblers will go back to the sportsbook instead of trying to find a rush in the stock market and volatility will subside some.  We aren’t counting on it which is why we remain fully invested in a well diversified portfolio, as should you.

Disclosures & Index Definitions

Under style performance boxes, indexes referenced in the equities section for large, mid and small reference the Russell 1000, Russell MidCap and Russell 2000 stock indices, respectively. The Barclays US Government, Barclays Credit and Barclays High Yield fixed income indices refer to Gov’t, Corp, and HY, respectively. Short, Intermediate and Long refer to the time frame of the investments and their positions on the yield curve.

The information and opinions stated in this presentation are not intended to be utilized as an overall guide to investing; nor should they be taken as recommendations to buy, sell or hold any particular investment. This presentation is not an offer to sell or a solicitation of any investment products or other financial product or service, an official confirmation of any transaction, or an official statement of presenter. The opinions and views conveyed are for informational purposes and make no recommendations in regards to how a client’s portfolio should be managed, as that involves inquiring, in depth, of a client’s or prospective client’s risk tolerance, investment objectives, time frame for investing and any other details pertinent to said client’s or prospective client’s financial situation. The presentation may not be suitable to be relied on for accounting, legal or tax advice.

Past performance is not indicative of future returns. Prices and values of investment vehicles will rise and fall as broad market conditions change. Investors’ portfolios may fluctuate, to varying degrees, in tandem with market conditions.  Diversification neither guarantees returns nor does it eliminate the risk of a portfolio decreasing in value. Equity securities tend to be more volatile than bond/fixed income products and carry greater risk factors than that of fixed income products. Smaller capitalization equities (i.e. mid and small caps) typically involve more risk than that of larger capitalization stocks. Political, economic, and currency risk are all risks subsumed under the additional risk factors of investments in international securities, to include  those in both developed and emerging markets. In addition, political conditions in emerging markets can tend to be more volatile than in those of developed markets.

Investments in bonds will be subject to credit risk, market risk and interest rate risk. Interest rates will have an inverse effect on prices of bonds. Bonds of lower credit ratings, also known as High Yield bonds which hold a rating of less than investment grade (BB+ and below), will have greater risks attached than will those of investment grade bonds and will experience greater volatility.

All dates are as of August 31, 2020, unless stated otherwise.

Presentation prepared by Financial Advisory Service, Inc., an SEC Registered Investment Adviser. Securities offered through FAS Corp., an affiliated insurance agency and broker/dealer.

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Index Definitions

The S&P 500 Index is based on the market capitalizations of 500 large companies whose stocks are listed on the NYSE and NASDAQ. This is widely regarded as the single best gauge of large cap US Equities.

The Dow Jones Industrial Average  is a price-weighted average of 30 actively traded blue-chip stocks, primarily industrials. It is used as a barometer of how shares if the largest US companies are performing.

The NASDAQ is a market capitalization weighted index of the more than 3000 common equities listed on the NASDAQ Stock Exchange. These securities include American Depository Receipts, common stocks, real estate investment trusts, and tracking stocks.

The MSCI EAFE (Europe, Australasia, Far East) Net Index is recognized as the pre-eminent benchmark in the US to measure international equity performance. It comprises the MSCI country indices that represent developed markets outside of North America, Europe, Australia, and the Far East.

The MSCI Emerging Markets Index captures large and mid cap representation across 23 Emerging Markets (EM) countries. With 822 countries, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

The Barclays US Aggregate Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS, ABS, and CMBS.

All index information has been gathered from public sources who are assumed to be reliable, although we cannot guarantee the accuracy or completeness of those public sources.