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We just got a free pass, don't let it go to waste!

April 2020 just witnessed the fastest rally for US equity indices in history. The acceleration to the upside was simply staggering. The cover chart of this note shows the April rally in the context of previous market bottoms.

Granted, one could argue that the drop was at fast and unexcepted. And that is what this note is meant to discuss.

The GFC of 2008 was followed with 11 years of unidirectional (upward) move in equities following (a 500% return since lows of March 2009) where the Sharpe on S&P500 was often above 2 and sometimes as high as 4. This relentless risk-on mode, provided many investors with a sense of security. The lack of major roadblocks in those 11 years, combined with very low interest rates, subdued volatility and the new reality that Central Banks were ready to do it all (the famous Fed Put option), emboldened all and as years went by the concerns about (downside) risks faded.

Even savvy and veteran investors who had lived through bear markets and risk-off episodes of the past were facing a dilemma: they knew that unknown risks can always materialize but the pressure of underperforming in an ever rising market - by either being underweight or using hedges and overlays - had many adopt the view that "we can be reactive when we see signs of trouble".

And then, the pandemic caught all of us off-guard. Much pain was felt and a lot of leverage got unwound. And yet here we are: after a brutal 30% plunge in S&P500 (remember to make up a 30% drop one needs to generate 50% returns) we rallied nearly 35% in less than 6 weeks! (less than 15% away from pre-crisis all time highs)

Can we rally further? Sure. I have learned over the years that everything is possible and the key is to assign probabilities. Let's have a quick review of where we are.

  • The economic effects of the pandemic and lockdowns are staggering and based on data available so far resemble those of the Great Depression (or worse in some cases). Q1/GDP: -3.8% Eurozone, -4.8% US, -6.8% China, etc.

  • Action of the Fed (and other Central Banks) are also unprecedent in history and have most likely taken away the systemic risk to the financial system

  • Many businesses and sectors (hospitality, energy, ...) are permanently damaged and/or will disappear, while some have flourished (FAANG & co.).

  • It is very difficult for most investors to put a clear "value" on many stocks, and much uncertainty remains on the horizon. (Today's surprise: BP cut dividends by 66%, BP is the biggest dividend payer in UK's FSTE100)

  • Baring a medical breakthrough and/or vaccine the "new normal" even after lockdowns and confinements are eased will not resemble the "old normal". People will not be traveling and eating at restaurants and spending in the pre-pandemic mode.

So yes, we can rally but we could also experience other scenarios: correction whether slow or brutal or going sideways (remember the 1960s?).

I am not an equity investor but here is a question any investor needs to think about in the context of their portfolio (talking index level and ETFs and not about stock picking):

“Do I buy equities at this level (i.e. S&P500 approx. 2950)?

If yes: what upside I see for the next year or so?

(for instance: reaching pre-crisis all time highs or higher)?”

Now even if one sees upside, or needs to be invested because of his/her mandate (as it is the case of many institutions), here is another question:

“Are there any downside (correction) risks I am exposed to going forward?

If yes: how I am addressing these risks?”

If one is of the view that there are barely any risks ahead and it is simply fine to be invested in equities and ride what might come to us, then what follows will be of no interest to him/her.

But if like many veteran investors, while optimistic about the long-term future one remains risk-aware (personally I think we should all be), then thinking about how to avoid the risks of a second correction (and/or using as an additional entry point) or a W-shaped recovery is a must. (chart courtesy of SG cross-asset research)

At this juncture, it is important to bear in mind that while equities keep rallying, other assets do not signal a traditional risk-on behavior: precious metals also keep rallying, commodities have stabilized at lower levels, long-term interest rates remain subdued (yes in part due to CB buying) and credit has firmed up but has not participate in the latest legs of the up move in equities.

“This tremendous rally in equity markets is an amazing "free pass" (and a wake up

call about risk) because it is providing everyone the opportunity to reinforce their

portfolios and immunize them against potential future risks while remaining invested.

It is wise to cease this opportunity.”

One way to implement adequate risk-management in a portfolio is the astute and proper use of options. And no, it is not true that overlays and hedging are always a drag on performance. Like most other things (asset allocation, sector exposure, etc.) it is all about how one uses them.

Here is an example (not a recommendation to buy or sell and only for illustration):

If an investor is long the S&P500, for the next 8 months he/she can participate fully on the upside up to pre-crisis highs while cutting his/her exposure by 50% if the S&P500 falls by more than 15% by then. The graph illustrates the pay-out.

There are virtually myriads of other ways of addressing specific risks and outcomes in a portfolio by using option overlays (for upside, downside, event or stock specific situations ...)

That is what we specialize in at LFC. We can help design simple yet purposeful overlays (liquid and cost-effective) that help control risk and improve the risk/reward ratio as we move into the uncharted territory of the "new normal".

Do no hesitate to reach out. Who knows what tomorrow is made of!

- Kambiz Kazemi, CFA, P.Eng.


This report is published by La Financière Constance Inc. (LFC) on April 30, 2020 and is intended primarily for institutional investors. It is provided as a general source of information and should not be relied upon as investment advice, a forecast or research, and is not a recommendation, offer or solicitation to buy or sell securities in any jurisdiction or to adopt any investment strategy. The information contained in this report has been obtained from sources believed reliable; however, the accuracy and/or completeness of the information is not guaranteed by LFC, nor does LFC assume any responsibility or liability whatsoever. All opinions expressed are subject to change without notification. LFC strategies and investment vehicles may currently hold long and/ or short positions in the securities and derivatives mentioned in this report. Past performance is not indicative of future performance. This report may contain “forward-looking information” that is not purely historical in nature. Forward-looking statements are not guarantees of future performance and involve inherent risks and uncertainties about general economic factors. There is no guarantee that any forward-looking statements will come to pass. We caution you not to place undue reliance on these statements as a number of important factors could cause actual events or results to differ materially from those expressed or implied in any forward-looking statement made. This report may not be reproduced, distributed or published without the written consent of LFC.

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