But the reversals can be just as vicious since things that go up rapidly tend to come down just as rapidly. And what if they did in a correlated fashion where diversification between risky and riskless assets did not help? Is there a way to participate in the upside by actually being long risk assets such as stocks, while cheaply buying some sort of downside protection? Can unexpected changes in correlation come to rescue us from our indecision?
And what does the market think? As an exercise I computed the theoretical cost of a “put” option that protects against a decline of 5% or more in the S&P500 in a year. This option based market insurance costs about 5.5% (so to protect the value of a million dollar portfolio for losses beyond the first $50,000 in losses would theoretically cost about $55,000 a year).
How about the same put option which is contingent on yields rising? Remember we said above that the market prices the correlation between yields and stocks to be positive, i.e. if stocks fall, the market expects that yields will fall as well. But what if the unexpected happens, i.e. yields rise as stocks fall, or maybe stocks fall because yields rise (probably after the last shorts in the bond market capitulate, or a sovereign credit crisis, or a central bank mistake)?
Well, the market will today pay you to take the other side of the correlation risk. A “hybrid” option that relates the equity market and the government bond market with the same equity market strike as the put option above has a theoretical price of 25% of the price of the plain vanilla put (i.e. $12,500 on a $1MM portfolio of stocks) as long as in 1 year yields on 10 year US government bonds are above their current (almost a record) level of about 1.6%.
So if stocks fall and yields rise, you could possibly get yourself protection at a large discount. Not everyone can and should look at investing in these types of “exotic” options (there are numerous problems such as illiquidity, lack of transparency in pricing etc.), but the fact remains that the correlation market is very one-sided today, and quite unprepared for an unexpected breakdown in correlation.
Which is to say that when we run out of ways to expect the unexpected, a good idea is to flip the analysis on its head and “unexpect the expected”. The positive correlation between stocks and bond yields is what is expected by the markets through decades of conditioning. If we momentarily shake off our biases and preconceived notions on such “historically true and tested relationships” between asset classes and investments, we might find ourselves looking at some interesting opportunities that we can easily overlook otherwise.
Unexpect the Expected to Uncover Opportunities, Forbes
Vineer Bhansali, Ph.D. is the Founder and Chief Investment Officer of LongTail Alpha, LLC, an SEC registered investment adviser and a CFTC registered CTA and CPO. Any opinions or views expressed by Dr. Bhansali are solely those of Dr. Bhansali and do not necessarily reflect the opinions or views of LongTail Alpha, LLC or any of its affiliates (collectively, “LongTail Alpha”), or any other associated persons of LongTail Alpha. You should not treat any opinion expressed by Dr. Bhansali as investment advice or as a recommendation to make an investment in any particular investment strategy or investment product. Dr. Bhansali’s opinions and commentaries are based upon information he considers credible, but which may not constitute research by LongTail Alpha. Dr. Bhansali does not warrant the completeness or accuracy of the information upon which his opinions or commentaries are based.