After record-level volatility to start the year, both the S&P 500 and the S&P/TSX Composite Indices have risen more than 10% from the February low. Moreover, after the historic Brexit vote and subsequent overnight global market sell-off on June 23 of this year, global markets managed to recover quickly and the S&P 500 managed to reach a record high in July. That same month, for the first time ever,Germany issued zero coupon bonds that are sold above par value. In other words, investors pay the German government to borrow money for 10 years.
In light of the current situation, investors might wonder whether earnings improved over the second quarter (Q2) of 2016. According to FactSet’s quarterly research, the Q2 blended earnings decline for the S&P 500 was -3.2%. More importantly, Q2 marks the first time the Index has recorded five consecutive quarters of year-over-year earnings declines since Q3 2008 through Q3 2009.
At the same time, however, valuations for S&P 500 stocks are rising. As of September 9, 2016, the forward price-to-earnings ratio is 17, significantly higher than the 5-year average of 14.3 and the 10-year average of 14.8.
As an investment manager, my job is to identify and manage the risk of market anomalies. We must understand and define the risk and choose the best execution strategy (i.e., whether to ignore, reduce, assign, or eliminate the risk). Eliminating risk can be costly. For example, an investor may have chosen to eliminate drawdown risk by selling his or her profitable stock positions following the market rebound in March. However, if an investor had sold his or her stock positions after the initial recovery, he or she may have missed over 5% in gains from either the S&P/TSX or the S&P 500 Indices as of September 13, 2016.
On September 9 of this year, market volatility surged on fear of a potential interest rate hike on September 21. Speculation on a rate hike, which has been dominating the headlines for the past year, seems all too familiar. We all know that eliminating equity price risk may not be the best course of action, as suggested by the performance of both the S&P 500 and the S&P/TSX Indices since the first rate hike in December 2015.
Regardless, whether the Federal Reserve decides to raise interest rates or not, investors should gear up and be prepared for the volatility that arises from the crystalizing rate-hike scenario. From a fundamental perspective, the U.S. economy has been improving. According to the U.S. Census Bureau, on September 13, 2016, median household income after adjustment for inflation rose by 5.2% from a year earlier, the largest annual gain recorded since 1967.
With stagnant earnings growth, high valuation, and a potential rate hike, we believe advisors and investors should position themselves where they can assign and reduce volatility risks. I recommend using BMO Covered Call Canadian Banks ETF, and BMO Covered Call Dow Jones Industrial Average Hedged to CAD ETF . These Exchange Traded Funds (ETFs) are helpful if derivatives are not at your disposal. Even with the capacity to trade options, I would use them if I wished to lower my equity exposure quickly or to deploy capital when volatility is still high. Considering the time and trading cost required to run a covered call strategy, I think the management expense ratio for these ETFs are reasonable, making them very cost-effective tools to simultaneously gain equity exposure and lower volatility. The objective of a covered call strategy is to give up some of the upside by selling call options and use the premium from the sale of call options to generate yields, effectively lowering volatility risk. Given the increased volatility and current high risk-to-reward ratio, these cost-effective ETFs should serve their purpose.
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This communication is intended for informational purposes only. This update represents the assessment of the markets at the time of publication. Those views are subject to change without notice as markets change over time. The information contained herein is not, and should not be construed as, investment advice to any party. Investments should be evaluated according to the individual’s investment objectives. Professional advice should be obtained with respect to any circumstance.
The statistics provided in this article are based on information believed to be reliable, but BMO Asset Management Inc. cannot guarantee they are accurate or complete.
The recommendations and opinions expressed herein are those of Leon C.L. Yin, CFA®, Investment Advisor, HollisWealth, a division of Scotia Capital Inc. and do not necessarily reflect those of BMO ETFs, and are not specifically endorsed by BMO Asset Management Inc.
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