Exploit low volatility for hedging purposes

What’s behind the rally anyway?
The major stock market indices have racked up gains of between 11% and 18% since the annual lows they hit in June. One significant factor behind this move is of course central bank monetary policy. The prospect of renewed quantitative easing measures – this time especially by the ECB has led to price increases in all risky asset classes. In past years, these stimulative measures have repeatedly given a boost to stock prices. However, the effect on the markets was usually ephemeral. And the effect of these measures on the real economy is now becoming an increasingly heated topic. Clearly less support has come from the macroeconomic data to the contrary, the world economy has weakened noticeably of late. But one positive element is the fact that companies continue to hold up successfully in this difficult environment: a good 70 % of US firms and roughly half of all listed European companies have managed to beat analysts’ expectations. However, the improved earnings are hardly attributable to revenue growth, but instead to even stricter cost management.

The air is getting thinner
The key stock indices all remain in an intact uptrend. There is also a green light in terms of valuations: despite the recent rally, they are still attractive – especially when viewed against government bonds. Nonetheless, the higher stocks go, the thinner the air will get at least for now. Based on short-term indicators, the markets are now in overbought territory and face stiff technical resistance levels. The recent gains have not been accompanied by increased trading volumes. Implied volatility readings are at historical lows, thereby suggesting a high degree of investor confidence. As a result, the indices are highly vulnerable to a correction if negative news hits the tape. In September, a number of important events and decisions are on the docket (EU summit, German Constitutional Court ruling on the ESM, Fed “Jackson Hole” conference, etc.), each of which could lead to (temporary) uncertainties and/or disappointments. Historically, September and October have exhibited a seasonal tendency to be difficult months for the equity markets. The leading indicators are pointing towards a further economic deterioration in the months ahead. In Europe as well as now in the USA, the purchasing managers indices are in the contraction zone something which should lead to further cuts in analysts’ earnings expectations. A decisive breakthrough in the battle against the debt crisis still appears to be a far way off.

Exploit low volatility for hedging purposes
The stock market gains of late have been considerable indeed. Even though the uptrend is still intact, the risk/reward ratio is now disadvantageous due to the aforementioned imponderables and the limited potential for further price gains. If market participants’ expectations e.g. as they pertain to central bank actions are not fulfilled, those gains could be taken back in a heartbeat. Equally spoken, the market’s anticipation of less violent price fluctuations also has its advantages: thanks to the historically low implied volatility, hedging instruments have become cheaper. Thus in our portfolio management mandates we have hedged a portion of the equity quota at levels close to current prices by means of a put option. In order to keep the financing costs of this “insurance policy” as low as possible, the hedge will be closed out at the previous lows for the year. This way, investors can still participate in a further rally while simultaneously enjoying a certain protection against future price turbulence. Active investors with sizeable exposure to equities should also consider hedging their positions and thereby buffer any temporary market downturns. We shall be pleased to assist you in choosing the hedging strategy that is right for you.

Media contact
Bernd Hartmann Head of Investment Research VP Bank Investment Research Tel +423 235 63 99 investment@vpbank.com www.vpbank.com

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