Despite the shock Britain's historic vote to leave the EU delivered to the financial markets, the second quarter saw most asset classes deliver positive returns. International stocks were the only major asset class down in the quarter. The best performing asset classes were long-term bonds, REITs, and Commodities.
Year to date REITs, Commodities, and Emerging markets lead the way.
The US equity market is up a nearly 4% so far this year, but this is offset by International stocks which are down 3%. All stocks (both US and International) are up a meager 1% year-to-date through June. Not too exciting.
When Stocks Go Nowhere
As we wrote recently, we are in one of the most frustrating market environments for long-term investors. The stock market bounced around a lot in the last year and a half, but ultimately, gone nowhere. In a recent article author Morgan Housel put it like this:
“The S&P 500 is a little lower today than it was a year ago.
One year of monitoring investments, tracking earnings, filling out tax forms ... and you get nothing.
How rare is this?
The optimistic answer is, not rare at all.
The depressing answer is that the markets neither know nor care about your goals, and often require years of patience to see any results.
Stocks have been lower than they were 12 months prior in about a third of all months during the last 130 years. So, we're in good company.”
So these flat periods happen, but knowing that doesn’t make enduring them any fun. It’s still frustrating and can lead people to ask some variation of the following questions:
- When will this end?
- Why don’t we just invest in things that go up?
- Are there any ways to make money in a flat market?
Let’s take a look at each question.
When will this end?
First, and most importantly, the answer is that we don’t know. Neither does anyone else. No one has a crystal ball when it comes to the markets.
Morgan Housel in his recent piece I quoted above, pointed out some very long periods where a market (the S&P 500 index in this case) gives you no return (see chart below). Adjusted for inflation, the S&P 500 index essentially retuned nothing over the 12+ years from September 2000 to May of 2013. This period is the longest such stretch on record and obviously a long time to wait for a positive return.
Source: Motley Fool
But, this flat return over the period is only in one market. As investors, we aren't limited to investing in one market, country, industry, etc. The point of being diversified is so that parts of your portfolio are working while another part may be doing nothing.
Look at the 2000-2013 period across other asset classes. While the S&P 500 was flat net of inflation over this period, other areas had positive and strong returns. Emerging market stocks were up 7.2% and REITs were up 9.2%—a 2.4x and 3.1x real growth in wealth respectively over the period.
Source: DFA Returns. All returns are annualized net of a 2.37% annualized Inflation (CPI) rate. Large Cap Value stocks are the Russell 1000 Value Index, Bonds are the Barclays US Aggregate Bonds Index, Small Cap Stocks are the Russell 2000 Index, Emerging Market Stocks are the MSCI Emerging Market Stock Index, and REITs are the Dow Jones US Select REIT Index.
Instead of trying to predict when things might turn for a particular market, diversification can help us build a more balanced portfolio and tap into other areas of returns when one specific market isn’t working.
Why can’t we just invest in things that go up?
We talk a lot about the importance of being diversified, but sometimes people will look at the recent performance of an asset class (emerging markets and commodities currently come to mind) and ask, why would we want to own that? Its recent performance has been terrible.
According to Meb Faber, it’s pretty rare for an asset class to be down in three straight years. But, when it is, future returns are quite strong. The four times it’s happened previously the average return over the two subsequent years was 64%!
According to Meb, if history repeats, Emerging Markets and Commodities could be due for returns between 40% and 96% over the next two years, as they came into 2016 being down each of the last three.
This mean reversion doesn’t just hold true in asset classes through. Again according to Meb, countries down three straight years returned an average of 56% over the next two, sectors down three years returned 60% over the next two, and industries down three years returned 59% over the next two.
By investing based on what looks good in the rearview mirror, we are likely missing out on the best returns going forward.
Are there any ways to make money in a flat market?
Lastly, other than being diversified and not shying away from markets which have recently fallen, is there anything we do to help during flat markets? Enter options.
An option contract gives its owner the choice (i.e. the option) to buy an asset in the future based on a price set today (called the strike price). The option to make a decision based on future prices is valuable and, therefore, has a cost. Those willing to sell options are essentially providing a form of insurance to the buyers of options. Because of this insurance component, selling options over time has an attractive return for those willing to do it.
To set the stage before we look at a couple of strategies, let’s define the two types of options: Puts and Calls.
Puts: A put option gives its owner the right, but not the obligation, to sell a preset number of shares for a predetermined price (called the strike price) by a predefined date.
Calls: A call option, on the other hand, is the right but not the obligation, to buy a preset number of shares for a predetermined price by a predefined date.
There are two common strategies for selling options into the market and pocketing the option premium (i.e., the proceeds from the sale): a “PutWrite” and a “BuyWrite” strategy. Here’s a quick summary of each before we look at their performance in different market environments:
- PutWrite (Writing puts): A PutWrite strategy involves systematically selling puts over time and generating returns from the premium received. Cash is held to cover the purchase should one be obligated to buy (i.e., get "put") the shares. The upside is limited to the premium received (the income), and the downside is equal to owning the underlying shares minus the premium received.
- BuyWrite (Writing covered calls): A BuyWrite strategy is when one systematically sells calls over time on a stock they currently own. Because of the sold call, one’s upside is capped above the strike price and is limited to the premium received. Again, the downside is equal to owning the underlying shares minus the premium received — there is no protection on the downside.
The payoff profiles for both strategies are therefore similar—upside capped to the premium income with downside equal to owning the underlying position. The chart below graphs this payoff profile. In this example, a PutWrite strategy has a maximum gain at $70 or higher, as you get to keep the entire option premium. Any point below the strike price ($70 in this case), the put expires “in the money” and the seller is required to pay the buyer at settlement. For a BuyWrite, since you’ve sold a call at $70, you don’t participant in any gains above this amount even though you own the underlying stock. And since you own shares, you fully participant in the downside.
So, how do these strategies perform across different market environments? We split rolling 12-month S&P 500 returns into three buckets: down years (defined as loss of more than 5%), flat years (-5% to +5%), and up years (greater than 5% returns) and compared the performance of the S&P 500, the CBOE PutWrite Index, and the CBOE BuyWrite Index.
As you can see in the chart below, selling options (either the PutWrite or the BuyWrite) strategy outperforms on average when the S&P 500 index is either flat or down. During up years, these strategies lag (although not greatly) as you are giving up any gains above the strike price. The PutWrite strategy performs especially well in down and flat years, and the option premiums tend to be higher than those generated via the BuyWrite strategy. Conversely, the BuyWrite strategy performs better on average in the up years as writing options with a strike 2% over the current prices allows one to participant in a bit of the upside market movement.
Source: CBOE. 12-month rolling returns from June 1988 to July 2015
This relationship can also be seen clearly in the following scatter plot. Notice how the PutWrite strategy performs better (above the red line) in down and flat periods but lagged (below the red line) in strong return years. Its returns fit better to a curved, convex shape than a linear 1:1 line.
Source: CBOE. 12-month rolling returns from June 1988 to July 2015
So, to come back to the original question: is there anything we can do to help during flat markets? As we just saw, those willing to sell options and pocket the option premium can, on average, improve returns when the market is flat and mitigate some of the losses when the market drops. What remains is a question of timing: is there a way to exit the strategies when the market stops being flat? We will have to look at this another time.
While flat markets are clearly frustrating don’t let this frustration turn into impatience which tends to lead to mistakes. Remember the following:
- Thanks to diversification, even if one part of your portfolio is flat other parts can still see strong returns.
- While it may be tempting to only invest in what’s done well recently, realize that things performing poorly in the recent past may be the best place to invest going forward.
- Options strategies, due to the premium income generated, may be a useful strategy for you to protect in down markets and generate a return in flat markets. (Please note, not all options strategies are the same—some can be quite risky. If you use options, please understand the exposure you are targeting and use them appropriately.)
 The S&P 500 performance is total returns, including dividends, and both the PutWrite and BuyWrite index are constructed by selling one-month options and rolling them each month. The 2% OTM BuyWrite strategy sells call options with the strike nearest to 2% over the current market price.