When we were rebalancing our portfolio in early December, we looked at many reports by investment banks in order to gain a sense of what the S&P 500 was expected to return at the end of this year.
The majority of researchers were indicating a return anywhere from 7% to 12% – for the whole year. We are now 4 months into the year and the S&P has already returned 12%!
No fund, not even the most optimistic ones, saw such a huge rally coming. If we annualize the return based on the past 4 months, we are heading into a year where the S&P might return between 35% and 40%. This would mean one of the greatest market returns in the past 35years.
Valuation is subject of many things, one of them being the liquidity in the market. When examining how high the market could go, a key factor to look at is the value of global equities as a percentage of equities, bonds, and M2 (money supply) held by non-banks. Today, this figure is still far below what it was in the pre ’02 crash period, so as more liquidity finds its way back into the equity market, the market will undoubtedly head higher.
While it appears we might very well be on the way to a historic year for the S&P, incidents such as the Archegos meltdown and the GME fiasco signal froth in certain pockets of the market that every market participant needs to be aware of.Our hypothesis remains that the market is due for a pull back and a choppy few months.
Inflation: The Labor Slack is Going Away
Risk Level: Medium
Despite continued consistency in the Fed’s asset purchasing program, the risk of inflation was not something to be worried about in the past few months. There were simply too many deflationary factors in the market to cause any inflationary concerns. In the past week however, new data is now suggesting otherwise. The slack in the economy is going away much faster than anticipated. The GDP is growing and jobless claims are decreasing. As unemployment rates return to their pre-pandemic levels, the Fed will have no choice but to react.
Biden Tax Plan: Doubling Capital Gains Tax
Risk Level: Low
Last week, Biden and his administration introduced a potential tax hike on capital gains. Although extremely unlikely to be passed, should it in fact come into law, it will be another catalyst that could cause some uncertainty in the market. Historically however, taxes do not impact the market as severely as interest hikes do. If one looks back at previous tax hikes, the market has almost always recovered its initial loss in value.
Rate Hikes: Fed Increasing Rates Earlier than 2023
Risk Level: High
The biggest risk to the equity market remains the same: interest rates. Real-time data shows much higher than anticipated demand, and that could overheat the economy. The probability of a rate hike is therefore increasing and the timeline for same could be much faster than the 2023 timeline initially mentioned by the Fed. Long-duration assets such as growth stocks could again be impacted negatively if the rates do move higher.
How to Mitigate this Risk:
Long VIX and Other Options Strategies
One of the main strategies currently used to mitigate these risks is going long on VIX. Going long VIX allows you to hedge accordingly in case of any major rate hikes or tax increases. Using targeted puts (selling puts to open) and covered calls can be two other techniques that you can make use of to generate income and take advantage of a potential consolidation phase.
Offloading Long-Duration Assets
This could also be a great time to rebalance and offload some of the longer-duration assets in your portfolio (such as stocks with profitability timelines of 5 to 10 years).
As always, please email me if there are any questions or concerns.