Options Imply Little Risk of Market Corrections Anytime Soon

Rather than any severe declines, investors should be more concerned that the upside in markets will be quite limited for some time.

Markets are reaching new highs.

Photographer: Michael Nagle

A watchful Federal Reserve has created a buoyant environment for equities. The S&P 500 Index is on course for its least volatile year since 1964. On top of that, anticipated volatility as measured by the Chicago Board Options Exchange Volatility Index, or VIX, is near historical lows.

Although the lack of anticipated volatility in the S&P 500 is reflected in the VIX, the distribution of returns predicted by options tell a different story, indicating that equity holders can expect little upside potential by hedging downside risks. Put another way, options -- which provide extremely efficient estimates of the market's assessment of short-term risk -- indicate that the market is not sounding alarms over the likelihood of a severe near-term correction.

This is also true for the broader equities markets in Europe, U.K., Asia and in developing-nation economies. While the movie cliché "It’s quiet, almost too quiet" is usually quickly followed by some turbulent event, options are signaling that pacific conditions will continue almost everywhere for the time being, with global equities treading water, a counterpoint to the buoyancy that has led various indexes recently to touch all-time highs.              

The prospect for bonds is better than equities. Options indicate that longer-dated U.S. government bonds have an upside-to-downside risk ratio greater than equities, although the ratio is not indicating great attractiveness as it sits just below average long-term levels. This suggests the risks to bonds are gradually lifting real rates, which have far less of an impact on the long end of the yield curve than the short end, since option prices also signal that inflation risks are contained.

Gold and oil have limited upside-to-downside risk, options prices indicate. This is also consistent with the likelihood of inflation risk being muted and higher real rates, which would challenge physical assets such as gold and oil.

With U.S. inflation at 1.9 percent and the low unemployment rate of 4.4 percent, it may be the market believes the Fed is, or plans to be, ahead of the curve, having mitigated the risk of runaway inflation that would require aggressive tightening. That could tip the economy into a slowdown and equities into a correction. But given that we see muted inflation risk, we don't see the type of aggressive tightening happening that could derail economic growth. This is consistent with the so-called low negative tail risk to equities as implied by option prices. But any gradual rise in real rates would also be a headwind for equities, if only a stiff breeze rather than hurricane force, as option prices imply. 

Options are signaling that this is not the time to take exaggerated risks because of a lack -- if any -- of upside potential, rather than out of concern about the possibility of a large pullback in markets.

Equity markets seem to be operating on the premise that the low volatility that has buoyed performance in 2017 will continue unabated. The options market, however, appears to be more worried that the upside will be quite limited for some time, with the greater risk for a downward rather than an upward path.

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