An Umbrella for a Rainy Day

“The greatest risks are the risks that we don’t see, and the most difficult problem is in preparing in advance for that kind of thing.”

– Peter Bernstein

We are reading a lot of commentary about the Goldilocks macro environment that investors are considering as a potential outcome for the economy and inflation this year. In this scenario, the U.S. economy does not fall into a recession, but it is also not so hot that the Federal Reserve would have to keep the brakes on in the form of higher interest rates, and, thus, the economy could ease as markets currently expect. As a result, implied volatility, a measure of perceived uncertainty of price outcomes and a key input for pricing option contracts, for the S&P 500 Index is at the lowest level since the onset of the 2020 pandemic.

The combination of muted implied volatility and higher risk-free rates has brought down the cost to buy downside protection to equity exposure in option markets. Using a traditional option-pricing model, a 12-month at-the-money put option on the S&P 500 will cost around 4.3% in premium. That is at the lowest premium since 2007 and the ninth percentile of cheapness going back to 2005.

Are there storm clouds on the horizon? Well, there is always a laundry list of risks for markets to overcome in any given year, hence the adage of “climbing the wall of worry,” and this year has several potential risks we are aware of (and, of course, more that we are yet unaware of):

1. Economic concerns – While 2023 was the year of “the most anticipated recession in history,” and expectations of recession in 2024 have been dialed back, economists are still pegging the odds of a U.S. recession at 50-50 over the next year.
2. Interest rates – Renewed upward pressure on interest rates from growing concerns over U.S. federal fiscal sustainability, or sticky inflation (not our base case) restricting the Fed from easing monetary policy as broadly expected.
3. Geopolitics – With two ongoing kinetic wars and almost 50% of the global population facing general elections this year, geopolitical risks are elevated.

Option pricing for U.S. equity markets appears to be assigning a very low probability that any of the risks described above or unexpected shocks will have a negative impact on equity prices. As stated by Myron Scholes, Nobel laureate in economics and co-originator of the Black-Scholes option pricing model, in reference to global financial shocks: “Finding an umbrella in a rainstorm might be impossible or very costly.” For U.S. investors, it has rarely been a better time to buy that umbrella while the sun shines brightly on U.S. equity markets.