Goldman Sachs strategist Cormac Conners advised institutional money managers to consider hedging portfolios against a significant market downdraft. The methods for this type of protection aren’t advisable for all investors, but Mr. Connors’ research report is a warning to all market participants to remain vigilant against growing risks.
Mr. Conners provided five reasons portfolio managers to buy downside protection in the short term. The first is that derivatives markets reflect optimistic sentiment. The popularity of bullish bets has left futures and options betting on rising equities expensive and downside protection like put options attractively priced. In other words, it is currently cheap to hedge against a market downdraft.
The S&P 500′s 14.1 per cent year to date has been famously driven by a small number of megacap stocks. Goldman Sachs believes the narrowness of the rally increases the risk of a market decline, provided reason number two to buy protection.
U.S. equity valuations are also expensive relative to history and this is reasons number three. The forward price to earnings ratio of 19 times is in the 88th percentile relative to history. Mr. Conners writes, “when the index has traded at this level or above, the S&P 500 has experienced a median drawdown of 14 per cent over the next 12 months as compared with a 5 per cent drawdown over a typical 12-month period.”
Goldman Sachs estimates that current stock prices discount U.S. GDP growth of 2.0 per cent. The firm’s economists, however, expect only 1.0 per cent growth in the second half of 2023, leaving equities vulnerable to revenue shortfalls as growth slows.
Reason number five is fund manager positioning. Hedge fund leverage was low, mutual fund cash positions were high and foreign investors were underweight U.S. equities when 2023 began. These bets were removed as the rally progressed, and no longer provide a tailwind for equity prices.
It is important to note that Goldman Sachs as a firm is not bearish on U.S. equities. Chief U.S. equity strategist David Kostin has a 12-month S&P 500 target of 4700 which implies an 8.0 per cent return from current levels. Economist Jan Hatzius sees only a 25 per cent chance of a U.S. recession.
Mr. Conners’ report is nonetheless useful as a sign that risks are growing under the surface. Put options may not always be a good idea for the average investor but it is never too early to start closely tracking important risk factors in the market.
– Scott Barlow, Globe and Mail market strategist
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