Don't Fight The Fed, But Limit Downside Risk

Equity markets have rallied 31% from the lows of the year as monetary and fiscal measures have been put forth to save businesses and consumers in distress. Multiple stimulus packages totaling trillions have been injected into the economy in order to provide the necessary liquidity to prop it up, raising several questions to investors.

The most prevalent of them all, how has the market rallied over 30% given the fundamental deterioration of the US Economy? With unemployment at 14.4% (LBS reported at the end of April) and corporate profits at an all-time low, how can market valuations be so imprecise?

The answer lies in one time-tested rule that investors are abiding by. "Don't fight the fed."

It was easy to decipher Jerome Powell's rhetoric over the weekend as optimistic about the US economy moving forward. Powell is predicting a strong second half of the year predicated on the proper stimulus measures being passed in Washington. "We're not out of ammunition by a long shot," he said on a 60-minutes segment.

The credit market has seen an extreme selloff as investor's flock to safe-haven assets bringing yields down to .70 for the 10-Year Treasury Bond and .17 for the 2-Year Treasury Note. It is clear that the bond market is pricing in a large falloff in economic activity and this inconsistency with the market's 30% surge from the year's lows has many equity investors concerned.

While the discrepancy in the credit and equity market is nothing to bat an eye at, I still remain optimistic about the equity market moving forward. Remaining invested has been the best strategy in all economic downturns and it is this bullish bias and sentiment surrounding markets that have allowed it to rally to current levels, still with potential to run given Powell's implications of future stimulus.

On the medical front, numerous healthcare companies are putting their full efforts into developing a vaccine for COVID-19. In most recent news, Moderna's positive early results have proved to be a catalyst to the market as the Dow is up 811 points (as of 12:25 PM 5/18/20) on the news. These catalysts will persist in the coming months and help to increase market resiliency.

One way to hedge against a long position in the markets is by buying puts against the market. Even though the VIX (Volatility Index) is down 65% from its high this year, it still reads a level of 29.18 at the time of writing this article which is a 79% increase from its level a year ago. Clearly volatility is a given in this market-environment and is easily identifiable in the intraday swings that have been occurring as of recent.

In my opinion, staying long and buying puts against the market is the best way to generate alpha in a portfolio right now. This strategy allows investors to both capture gains as the fed says it will remain accommodative while also hedging against the potential risks of a selloff by capitalizing on the volatility that still remains in the market.

By: Matthew Cerminaro

Thank you for reading! You can check out more of my posts on my blog here or take a look at my IG: @essentialsofinvesting for more market-related and personal-finance topics.