2023-10-06 14:40:05 ET
Summary
- The S&P500 Index has had a double-digit return over the past 12 months, but optimism among investors seems muted.
- The Federal Reserve's policy of normalizing interest rates and shrinking its balance sheet is causing uncertainty in the market.
- Historical data shows that returns have been influenced by the Fed's actions, and future expected returns may be lower due to the end of easy monetary policy. A buffered investment strategy can help manage risk.
In the face of continued hawkish Fed policy, the S&P500 (SPX) is still delivering double-digit returns over the past year. Despite the index's popular investable benchmark SPDR S&P500 ETF (SPY) hitting a rough patch recently, the total return has exceeded 14%.
Analysts are also continuing to increase EPS estimates for the index, which normally would support continued positive returns but optimism seems muted and it may be due to a story investors have read before.
This article reviews current Federal Reserve policy and how it correlates to prior periods, historical S&P500 returns since the early 90s, and how a buffered investment strategy can be used to manage risk and still achieve expected returns. The buffered portfolio strategy discussed uses SPY as an example but can be used with many other popular ETFs.
Normalized Interest Rates
There's been plenty to fear in equity markets lately as the yield on the 10-year treasury hit 16-year highs. Yields in general have remained elevated largely as a result of normalizing Fed rate policy and a shrinking balance sheet. As seen in the following chart, the effective Federal Funds rate is back to levels seen in 2006-2007.
We're at a point where the Fed seems content on holding rates steady so a natural question is how long might that last? The most recent rate hold period lasted from the end of December 2018 through about mid-July 2019 and marked the first attempt to end the ZIRP/NIRP experiment brought on by the Great Financial Crisis. The effective funds rate only got up to 2.50%, lasting about 6.5 months, before switching back to rate cuts.
The second most recent, and more comparable in terms of where the effective funds rate was then and now, lasted from roughly July 2006 to July 2007 before the rate cut cycle began. In both of these cases, along with the cut cycle that started at the end of 2000, rate cuts preceded recessions.
Fed Balance Sheet
Investors are justifiably jittery if the Fed has completed its rate hike cycle and are now content on holding steady. While rates might be held at current levels for what historically might be up to a year, continued pressure mounts on markets as the Fed continues to bleed off its balance sheet in what's so far been "QT-light". The following chart shows that the Fed had indeed reduced its balance sheet over the last year.
However, looking at how much the balance sheet has blown up since 2008 shows just how far the Fed has to go. The huge increase caused by the pandemic certainly didn't help the situation.
Historical Returns
Many credit the massive increase in the Fed's balance sheet with fueling market returns since coming out of the Great Financial Crisis and the following chart supports that proposition. The chart below shows annualized returns by purchase date for every day anchored to today for SPY, excluding the last year.
It's evident from the chart that returns were juiced coming out of the Financial Crisis bottom. Higher returns are expected from buying the low, but even purchases of SPY made years after the bottom have experienced above-average returns. The following table shows average annualized returns by year.
It's noteworthy that all of the yearly returns are positive and that even those purchases made in 1993, having been through several boom/bust cycles, hit 9.67% on average. Also clear are the double-digit returns starting in 2008. Of course, these purchase dates have the benefit of seeing fewer tail-risk events but also benefit from historically easy monetary policy. The worst years to buy SPY were 1999-2000, but even those investors managed close to 7% returns for impeccably bad timing.
The following chart shows another angle at measuring historical returns. The chart shows every possible 1-year holding period from 1993-present.
Most of the periods yield positive results, and the main negative periods are focused on major tail risk events like the Tech Crash and Financial Crisis, and more recently Pandemic Crash. Overall metrics for the period are given in the following table.
The average return of 11.10% over the entire period only really occurs from 2008 onward when reviewing the by-year average data covered earlier. All of the years prior don't hit double digits. It is a tale of two worlds, before and after the Great Financial Crisis. Or before and after ZIRP/NIRP and a ballooning Fed balance sheet. The median return of 13.35% sits well above the average return of 11.10% and goes to show how much big negative returns can impact overall return.
The following table breaks up return data into percentiles to give another helpful view of the data.
Projected Returns
The following chart shows 1-year total returns based on the prior 1-year total return. The trendlines for each help show the amount of correlation between the two figures.
Using the most recent 1-year return of 14.14% and plugging it into the trendline formula for prior 1-year return yields,
0.1414 = 0.000074x -0.16506, where x = 4141
We then use the solved x value and plug it into the 1-year trendline formula,
y = 0.000010 (4141) + 0.072290, giving y = 11.37%
So the expected future 1-year return based on the most recent 1-year return is 11.37%. This is a generic model with drawbacks but gives an idea nonetheless of the correlation between returns.
The 11.37% expected return would certainly seem reasonable in the easy monetary policy period before the Fed's recent historically fast-paced rate hike cycle intended to reel in inflation. However, based on where things stand now, it's not in my opinion a probable outcome, especially given the history of held rate periods followed by an eventual rate cut with the associated tail-risk event that usually shortly precedes or follows it. The end of easy money coupled with a higher probability of a tail-risk market event within the next year would lower future expected returns by several percentage points. Mid-digit returns may be the best-case scenario over the next decade.
Of course, as history does tend to repeat itself each event always has its idiosyncrasies and nobody can predict the future of markets with 100% accuracy. Therefore, a method of participating in expected returns while protecting downside risk is prudent.
Buffered Position Strategy
One way to participate in potential price appreciation while providing a set amount of downside protection is to create a buffered position with LEAPS (long-term equity anticipation options) options. For example, while owning 100 shares of SPY at $424 the buffered strategy involves simultaneously buying a bear put spread and selling a short call option at the Jan 16 2026 expiration as shown below.
The options position should be opened at net even or for a slight credit, and using the farthest-dated LEAPS provides the largest amount of downside protection but also reduces the annualized return that can be achieved. This particular trade gives downside protection down to the $335 strike, roughly 21%. This means that the first 21% of losses are hedged before the position starts realizing losses.
On the upside, potential returns from price appreciation are capped at the $510 call strike. This limits price gains to 20.28%, or 8.41% annualized. Since shares of SPY are held we're also entitled to receive dividends. While not guaranteed, we can reasonably expect to add the current yield of 1.53% for SPY to increase the annualized return potential to 8.41% + 1.53% = 9.94%.
So at the end of the day, we've created a position on SPY that can capture total returns up to 9.94% annualized while hedging the first 21% of losses. That 21% downside protection isn't likely to cover the entire downside of a significant tail-risk event. Covering even half the loss while capping potential gains at what is likely above the expected future return anyway seems like a good deal.
Buffered Portfolio Update
I first started my buffered portfolio strategy in mid-September of 2022 and first wrote about it on Seeking Alpha in an article titled, Failing Banks And A Looming Recession Highlight The Need For Risk Mitigation In Your Portfolio , in May of this year. I've added a few positions since then and have experienced decent gains while mostly zeroing out losses on losing positions. The following set of tables outlined the positions and associated performance of each followed by the overall performance between May and now.
The first table shows the cost basis and current strike prices for associated LEAPS options for each position. Note that over the course of time, short put and call options are rolled up and down in response to changes in underlying share prices so what is currently shown is likely not what was originally opened. This process is covered in more detail in an article I wrote on buffered ETF products which can be reviewed by interested readers.
The next table highlights returns made from net premium credit mostly from rolling short options along with dividends received. Maximum gains for each position are shown along with annualized figures for more direct comparison. The last two columns show the amount of downside protection that the current bear put spread has available with respect to the underlying cost basis and the amount of buffer that exists between the current underlying price and the price where the investment principal will be impacted.
The biggest drags in the portfolio consist of [[TAN]], [[KRE]], and [[ICLN]]. Shortly after opening positions in KRE, the regional bank debacle hit, and while disappointing I appreciated having the ~30% hedge in place to absorb almost all of the losses. Solar and clean energy have just been bad investments. Rolling short call options down in response to the big dips in the underlying ETF share process has resulted in maximum annualized gains resting in low single-digit territory, but it's much better than a ~30% loss.
The final table shows the profit and loss from each position on paper. Note that the nature of these positions is such that they have to be held until options expiration to achieve the listed gains. Closing positions that have big paper gains early will result in forfeiting a large chunk of those gains. All annualized figures use the opening date as the starting period and the options expiration date as the end period. Opportunity cost is tracked and shows the annualized gain given up by placing the cap on gains. On the flip side, hedging by the bear put spreads are also tracked showing annualized losses absorbed by those positions. Finally, net premium credit is also shown on an annualized basis.
Several positions have already achieved maximum profit potential. Tech-heavy investments in [[SMH]], [[IGV]], [[XLK]], and [[QQQ]] have all done very well and provided a large portion of my gains thus far.
The overall current annualized return for the portfolio stands at 6.23%. Again, it is important to emphasize that I'm using the option expiration date as the end period and not the current date. Opportunity costs are running at 0.83%, but are offset by a -2.37% hedge rate. Returns from net credit premiums from rolling options account for 1.67% of portfolio returns.
Since May, portfolio gains from price appreciation have increased by almost $13,000, net premium credit increased by about $3,900, and another $1,277 worth of dividends have been received.
Conclusion
The end of easy monetary policy marks the end of the decade-plus-long punch-bowl era for markets. Complacent investors perhaps got too comfortable with the idea of double-digit market returns forever into the future. The realization of history repeating itself in some variation justifiably raises red flags and it lies not in rising rates, but when rates get cut again. So it becomes more and more difficult to stay invested with the idea of just eating whatever tail-risk event is about to happen and that over the long term...you'll be fine.
It is very prudent to provide at least some form of downside portfolio protection. The buffered LEAPS strategy provides just that with what may be acceptable opportunity cost when considering future market returns will likely not be as robust as what investors got used to. Trade in those double-digit expectations with mid to high single-digit market returns moving forward and protect yourself in the process.
For further details see:
Setting Expectations For Market Returns & Managing Risk, Plus A Portfolio Update