Headlines Turning Bleak!
Fears of resurgent inflation battered bonds, toppled Wall Street from record highs and sparked speculation that central banks globally might be forced to tighten policy more aggressively- Reuters.
European and Asian equities fell as U.S. futures headed lower as global stocks extended the biggest selloff since 2016. Treasury yields crept higher while the dollar remained steady –Bloomberg.
News headlines concerning financial markets are turning bleak. The market sentiment for equities in the United States and across the world is turning negative. Investors are worried that inflation could force central banks across the globe to raise interest rates to combat a resurgent inflation. If interest rates rise, then bond yields would also rise, posing a significant threat of a stock market exodus.
Investors on Wall Street are arguing that wage growth and an acceleration in economic growth are more than enough to convince the federal reserve to end its decade long policy of ultra low interest rates. This argument along side the bonds yield argument are enough to convince investors that equities can no longer be the high yield investment they used to be.
What Is It With Bonds?
As bond yields rise, investors realize that they could potentially gain a higher yield in the bond market than they would in the equities market. For the last nine years, low interest rates have forced investors to put their money into equities, which yielded 15% (on average) in annual returns since 2008. This was a very easy formula for investors to follow, all you had to do was borrow money at 5% interest (even as low as 2.2%), put the money into equities and realize at least a 10% annual return (after paying back the interest). This recipe will no longer work and investors in 2018 know that. Investors are fearful they may no longer get better returns in the stock market than the bond market, so they decide to sell equity and look towards corporate/government bonds.
What To Do If The Market Crashes?
Investors have the option to short stocks, but that strategy can only be employed if investors know which stocks to short. A general rule employed by asset managers is to short the worst performing stocks from the previous year. This is because investors take less risk during a correction and punish stocks that have underperformed the prior year. Moreover, investors during a market correction are more likely to punish stocks with poor financials.
If You Can’t Short, Then Put!
Some investors don’t like the risk associated with shorting stocks, but still want to capitalize on any incoming market correction. You might think that shorting is the only option, but there are other “options” available, literally! Investors can purchase financial contracts known as “put options”. Put options are exchange-traded contracts or “options” to sell assets (in this case stocks) at an agreed price on or before a particular date. If you have done your research and you already know which stocks will drop the most in a market correction, then you can simply purchase put options on those stocks. A put option would allow you to sell these stocks at an agreed upon price even if their price drops well below the agreed upon price.
What If I don’t Know Which Stocks To Act On?
If you are stumped and don’t know which stocks to act upon but still want to capitalize on a market correction, then you can choose futures instead. More precisely, you will want to look at purchasing put options on index futures. Index futures are cash-settled contracts on the value of a particular stock market index (S&P 500, Dow Jones, etc). By definition, a stock market correction is a drop of ten or more percent in the value of each of the stock indices. So when we talk about a correction, we are really talking about a drop in the value of stock indices.
As market indices drop, the value of your put options on index futures would appreciate in value, thus allowing you to capitalize on any market crash. You can then turn around and sell your put option contracts for a profit. Alternatively, you may opt to exercise your put options, which could net you higher profits, in theory!