Sometimes it seems we know least that which we think we know best. This is often true of friends and family, and lately it seems to apply to our understanding of the economy, interest rates, and financial markets.
By traditional thinking, the red-hot stock market should be quite a bit lower, or at least much less robust, because economic data suggest the Federal Reserve is unlikely to lower interest rates as quickly as investors desire.
But the stock market isn’t demonstrating any real weakness. The S&P 500 index is trading near record levels, mostly dismissing whatever bad news may spring forth from economic indicators that are used to evaluate inflation and thus changes in monetary policy.
The seeming disconnect between interest rates and the stock market suggests that investors aren’t asking the right questions. Perhaps the real message from the 2024 market—at least in this tender stage of the first quarter—is that interest rates can stay where they are and stocks can still rally, even if the Fed fails to lower rates as much as anticipated. As long as rates don’t rise any higher, the thinking goes, stocks should be OK.
The U.S. economy, often perceived as stubbornly hard to change, seems more dynamic than understood. Perhaps technology has enhanced productivity and production in ways that we don’t fully understand.
Higher interest rates make capital expensive, and that should chill risk appetites in listed and private markets. Yet, the opposite is happening. Investor sentiment, a key reason why stock prices have surged, seems fine.
Some people who have watched the rally from the safety of high-yielding money-market funds are questioning their decision to stay in cash. Strategies that use borrowed money to make money, such as private equity, are doing very well. Shares of
Apollo Global Management,
Blackstone,
and
KKR
are near all-time highs.
One riddle worth solving is how to create a margin of safety in a potentially overheated stock market. We know from recent experience that major economic reports that interfere with the rates-will-soon-be-lowered narrative could spark big stock declines.
We also know that options volatility is reasonable at the index and sector levels. Investors dazzled by paper profits can hedge without paying a lot. This could change if investors begin to believe different narratives about the stock market and interest rates.
We’ve recently discussed portfolio hedging, and we reiterated our preferred approach of selling put options in the heat of a big downturn. Now we offer an approach that combines the approaches into a one-by-two put spread.
The strategy entails buying one put and selling two puts with lower strike prices and similar expirations. The first is to protect your gains, and the second is to lower the cost of that protection.
With the
SPDR S&P 500
exchange-traded fund at $496.76, investors could buy the June $475 put for $7.22 and sell two June $425 puts for $2.42 each. If the ETF is at $425 at expiration, the hedge that cost $2.38 is worth a maximum profit of $50.
The June expiration covers the next three scheduled meetings of the Federal Reserve’s interest-rate setting committee in March, April, and June, as well as a deluge of economic data.
The trade has two key risks. If stocks keep rising, the money spent to hedge is lost. Should the ETF fall well below $425, investors will likely grimace over their obligation to buy shares at the strike price—even though that should be recognized as an opportunity to buy many of the world’s top stocks at sharply lower prices.
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