The Time Has Come To Buy Cheap Protection

Recently, we have written about the emerging tension between stubborn high inflation on the one hand and some very widely held and lazy assumptions about the future direction of interest rates and the economy.

Then came to a head this week when, surprise, surprise, inflation came in stubbornly high this past Wednesday.

The details are less important than the fact that the veil finally started to fall on those assumptions we have detailed previously. The best evidence of this is the dramatic shift in expectations for interest rate cuts.

  • The odds on a June cut plummeted from over 50% to around 20% after the inflation data came out.

  • Other meetings further out also saw a re-rating down of expectations as well. We are now at around 2 expected cuts for 2024.

The time before that we wrote about the fact that a stock market correction was overdue and all sorts of classic indicators were flashing all sorts of red. Well, markets fell 1%+ the day the data came out and after a brief rebound on Thursday fell sharply again on Friday.

We would like to bring both those themes together this week and talk about what you can do about it.

Perhaps the most likely is the fact that the Dow Jones - an old fashioned index full of old fashioned industrial companies that we have recommended before - is now only a couple hundred points away from 40,000.

That astronomical number is not just symbolically significant today but also a famous historical number. It was the title of a book (and magazine article in the late 1990s) that came to represent an entire era of excess around the dotcom bubble.

For years after the doctom bubble burst you could elicit a wry smile from many investors by saying: "well....I still remember when we were going to hit Dow 40,000."

The fact that the Dow never got there and has taken 25+ years to finally come close tells you a lot about both the rise and fall of financial markets and human's unfailing ability to believe in fairy tales.

The book's cover is sort of all you need to know that this was NOT sober analysis.

Now you can buy - perhaps unironically! - hats that say the same thing to celebrate finally arriving at our long awaited goal.

In honor of that still sky high stock market and the theme that we are overdue for a correction we thought we would:

  • Re-raise and reiterate our concerns about this increasingly likely event.

  • Talk about some mitigating strategies.

The question is what to do about it?

  • One of the simplest is to buy some downside protection.

  • Another is simply expect volatility to rise.

One of the points we have tried to make over the last 3-4 months is that markets are not just rising but they are rising smoothly. We showed the chart of the S&P 500 a few weeks ago with the caption of:

It doesn't get much better than this.

That is still true as you can see here:

This is super unusual!

So, thinking about how markets could revert to mean with high volatility and at least some downside protection.

This might be a rare time to consider buying stock options. We typically discourage that but there is no doubt that puts on the S&P 500 are incredibly attractive at the moment.

As a reminder put options are the right but not the obligation to sell some specified amount of an underlying security (or in this case, an index) at a later date in time. If the price of the security in question falls then the value of the put option obviously increases in price as the probability that there is a larger difference between the right to buy the underlying index and the actual price of that instrument.

Long story short, volatility being so low right now makes put options incredibly cheap. Just ridiculously so.

The VIX rose last week but still sits at a very low level.

See here:

Now there is a reason for that. The US economy continues to grow, liquidity is plentiful and all the other strengths of the current bull market that we cover all the time are still true. But when you are paying cents on the dollar for downside protection it can start to look very attractive.

This may be the time to start thinking about being some options - perhaps either just before the election or in early 2025. This may seem obvious in a few months or quarters but these strategies are cheap and available now. Don't let hindsight be 20/20 when complacency is high and alarm bells are already ringing.

You don't just know that markets could correct, you likely know the reasons that could be responsible. It can take longer than you might expect for investors and the wider market to face reality but you can and should begin planning now.


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