Investment strategy through the ‘up crash’ and beyond
How would you characterize the current market, and what might lead to a pullback?
Amy Wu Silverman: To some degree, this has been an 'up crash'. We looked at all S&P500 stock returns since March 30, which was the low point. When you analyze those returns, you see substantially more realized volatility on the upside than on the downside.
Volatility usually declines when option markets go up. We haven't seen that here: volatility is rising with the market. That means we have to take the usual metrics, such as the VIX, with a grain of salt.
Lori Calvasina: A pullback seems likely, but when we look at our data, it feels more like a late innings than signs of a clear top. As nervous as we are starting to get, we are just not seeing signs that now is the time to pull out.
Several factors could influence what we might call a garden-variety pullback of 5 to 10%: volatility around the midterm elections, rising interest rates, or delayed impact from the Middle East situation.
Companies have really honed their crisis management skills and they're doing a beautiful job of managing through. But those buffers and inventories don't last forever, and at some point, if this goes on long enough, the market is going to have to digest that.
Silverman: Correlation has been very low, which has helped dispersion trades and made the market structure of those trades very crowded. However, when that correlation starts to rip up, funds have to go to the exit quickly.
This is one thing that could take this market down: it doesn't have to be a geopolitical event, it could simply be the reflation of correlation.
"Companies have really honed their crisis management skills and they're doing a beautiful job of managing through. But those buffers and inventories don't last forever."
Lori Calvasina, Head of U.S. Equity Strategy, RBC Capital Markets
How can investors take advantage of this situation?
Silverman: The current spot up, vol up dynamic has created an incredibly expensive call wing. The upside trade is a lot more pricey than the downside trade. We've been talking to clients about a really simple structure, which is called a caller: you sell upside and use it to buy downside.
That means you're getting downside protection at very low cost. In some instances, because of this call exuberance, you're getting a net collection of premiums, so you're actually getting money in for putting on protection.
These trade structures take advantage of that fact that this call wing is completely driven by FOMO and Momo. We know momentum does tend to beget momentum, but we also know at some point that momentum stops.
"We know momentum does tend to beget momentum, but we also know at some point that momentum stops."
Amy Wu Silverman, Head of Derivatives Strategy, RBC Capital Markets
How should investors view software and AI in the current market?
Calvasina: I get asked all the time if AI is in a bubble. I do think there was some over-hype initially, but I think we're actually starting to turn the corner in terms of seeing real impact.
Callie Simpson: There were fears at the beginning of the year about how AI could disintermediate software, particularly as it pertained to the credit markets. But the IGV now is up 30% since its April lows.
Silverman: We are starting to see intra-sector dispersion within software. The skew is showing bearish sentiment on some and bullish on others. As the market starts to differentiate winners and losers, we may continue to see signs of life in software.
How might inflation affect the path of the markets?
Silverman: At a recent event with Canadian PM Mark Carney, he was asked what increasing defense spending means for inflation, and he said he believes it will go higher. That is similar to comments made previously by General Petraeus.
Calvasina: We're focused on marrying up these qualitative statements from global leaders into our valuation model. We're seeing price to earnings compression from higher rates and higher inflation, but an even stronger tailwind from earnings and AI.
