(Bloomberg Opinion) -- The unprecedented pace of the collapse in equities and ensuing rebound has left investors questioning where the intrinsic value of riskier assets really lies. While progress has been made in combatting the coronavirus pandemic and authorities have provided massive support for the economy and financial markets, one can’t look at the rally in the S&P 500 Index from its March nadir and deduce that only sunny days are ahead.
Historical data comes in handy to draw an objective conclusion as to whether the surge in asset prices is sustainable or has instead been driven by transient factors. But crises are rare, which means that historical “event-study” data are limited. Although time-series data are elusive, cross-sectional data are not. These are data that aggregate various sources of information and many thousands of data points at one particular point in time, serving as a rich multi-dimensional “crowd” source of information.
The information derived by these cross-sectional data is exactly what a market price reflects when drawing forward-looking estimates of the economy and markets, and it is the basis behind an informationally efficient market. The market prices of options play a vital role in informing market participants of what risks lie ahead, and given market efficiency, they often tell a reliable story. When viewed through the lens of options prices, the current equities rally appears tenuous.
Short-lived bounces in stock prices even as markets establish new lows do happen. Equities rallied in late 2008 in response to the Federal Reserve’s first round of quantitative easing and other programs aimed at providing liquidity and supporting the economy. While investors welcomed those moves, it can be argued that some didn’t fully grasp the harm being wrought on the real economy.
The options market had a different view. During that bear-market rally, options on the largest 100 members of the S&P 500 indicated a level of expected downside that was almost 40% greater than any expected upside. This imbalance was minus 2.4 standard deviations away from what would have been expected under normal circumstances. In other words, despite equity markets having soared 25% from their November 2008 lows, the options market was pricing in a base-case outlook so dire that the probability under normal conditions of such an outcome was just 0.8%. By the time the March 2009 lows arrived, the options market had changed its tune, indicating an expected upside to downside of a more benign minus 1.22 standard deviations – a level expected to be seen one out of every nine times.
Frighteningly, despite the cheers being heard from the recent rally in equities, the options market is currently not joining the party. Throughout the equities rebound, options prices on the top 100 stocks of the S&P 500 have been pricing in almost 40% more downside than upside, similar in magnitude to what was registered during the 2008 bear-market rally. This skewed outcome represents an even more daunting minus 2.5 standard deviations relative to its historical level.
At the same time, the options market sees a much more sanguine bond market with downside just 7% greater than the upside. And, just as important, the options market might be signaling that monetary authorities may be moving to targeting interest rates and that setting overnight rates below zero may no longer be in play, as Fed Chair Jerome Powell remarked last week. Such indicators signal that options markets tell a different story than the equity markets. And if history is any precedent, we might be on the cusp of a reversal.
While the options market is no “fan” of broader equities, it is a relative “fan” of the so-called FAANG group of equities. Across Amazon, Apple, Facebook, Google, Microsoft, Netflix – and even Tesla – the options market is pricing in just 10% more downside than upside. The options market may be seeing the rise and dominance of these tech companies as the “coronavirus” pain puts many competitive smaller companies out of business.
If the crowd-sourced information in options market prices is sending a clear word of caution, maybe investors should heed the warning: Think twice before getting sucked into a rally that could turn out to be a classic “dead-cat” bounce. The disconnect between what we see in the real economy – which point to long-term negative consequences – and what we see in financial prices post the March lows - which hit at only temporary consequences - widens for the worse.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Ash Alankar is the global head of asset allocation and risk management at Janus Henderson Investors.
Myron Scholes, who received the Nobel Prize in Economic Sciences in 1997, is the chief investment strategist at Janus Henderson Investors.
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