The Returns Of The Jedi
Summary
- Stock market returns come with risk and volatility.
- Those risks and volatility are a tradeoff for the higher returns.
- What level of tradeoff you choose depends on your mindset.
- Would you have taken almost the same returns for half the volatility?
- Would you want to massively outperform in bear markets? That is what a Jedi would choose.
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Today, we are going to look at the stock market with the mindset of a Jedi. Those fictional knights of the light that keep calm under extreme stress and focus on mastering their emotions. We will break down what strategy we think they would choose and why that is really relevant for your returns today. We will do so by looking at the returns of the SPDR S&P 500 Trust ETF (NYSEARCA:SPY).
Source: ETF.com
This is one of the largest ETFs in the market with an almost $300 billion market capitalization and continues to be the recipient of most passive flows.
“Your Focus Determines Your Reality.” – Qui-Gon Jinn
If you want to try and maximize returns, you can certainly dial up the risk. That comes with a cost of increased volatility and increased risk. But chasing that also often ends with poor returns. Despite a relentless pursuit of risk, the returns for the average investor have been, well, anything but average.
A key reason for this has been chasing stocks at the top and selling them at bottoms. This year has also shown notable volatility. The SPY was down about 30% at one point and has now rallied back up to a 6% gain.
Data by YCharts
Many investors panicked and sold SPY at the bottom and are now buying back now as the market has rallied. That will obviously detract from their performance. So, what if you focused on lowering your volatility to the point that you were able to stay invested through ups and downs?
“In My Experience, There Is No Such Thing As Luck.” – Obi-Wan Kenobi
While investors may blame poor returns on luck, they likely did set themselves up for failure by dialing up risk to the point they could not take it. So, what method would allow you to stay invested and give you about the same returns? Well, one thing that has been tried is the 60/40 portfolio which reduces overall volatility. Today, though, bonds represent return-free risk. With yields so low, and obviously, they cannot provide the buffer they once did. It is also very probable that we get a coordinated selloff in bonds and stocks from an inflation scare. So, bonds, at least Treasury bonds, are unlikely to work. Well, there is one such thing, but are you prepared?
“Use The Force, Luke.” – Obi-Wan Kenobi
Examining the data over 32 years, one thing stands out. CBOE Global Markets Inc. (CBOE) Put-Write Index did a wonderful job of reducing risks. The Put-Write Index, purchases Treasury Bills and sells at the money Cash Secured Puts on the S&P 500 index. In essence, it is ready to go long at the current price, but demands that the put purchaser pay him or her for that.
So, for the SPY ETF, which we are using as an example in this case, with the price trading near $340, an investor would start by selling the $340 put for November 2020 expiration. This option last traded at $11.46. Hence, an investor would get $1,146 to commit to invest $34,000 in SPY, a month from now. In other words, he or she gets a yield of about 3%, in one month, just to commit to go long.
This is different than going long directly as you are getting some money that can offset your losses if the market goes down. On the other hand, if the markets run up, more than you got paid in premiums, you lag behind. What is great about this is that, as markets fall, which they always do at some time or another, your premiums keep increasing due to a higher volatility index or VIX. Ok, that sounds great in theory, but you are probably wondering how this all shakes out for your returns.
“I Find Your Lack Of Faith Disturbing.” – Darth Vader
Over 32 years, the S&P 500 produced 9.8% compounded returns. Those returns came with a large standard deviation of 14.8%. The Put-Write index, on the other hand, produced 9.5% returns, but with a big reduction in standard deviation (9.9%).
Source: CBOE/Wilshire Associates
That is a fantastic reduction in volatility of returns. When one examines the maximum drawdown, we can see the Put-Write strategy outperformed in spades.
Source: CBOE/Wilshire Associates
The put-write index wins by losing less during the worst downturns. Notable was the over 22% outperformance in 2000 and the 13.5% outperformance in 2002.
Source: CBOE/Wilshire Associates
The same can be seen in 2008-2009.
Source: CBOE/Wilshire Associates
While all of that is impressive, we have not got to the best part. The overall BETA of the Put-Write Portfolio was a whopping 53% less than that of the S&P 500.
Source: CBOE/Wilshire Associates
“Never Tell Me The Odds.” – Han Solo
With market valuations where they are today, and many investors expecting low to negative returns, the odds are that the average investor will do even worse. The situation is ripe to deploy the best tool in our toolbox and target returns by writing cash-secured puts.
While this index-beating strategy worked, today, the index has a very high concentration in select stocks that are very expensive. The average P/E of stocks held in SPY is almost 36, and the average Price to book ratio is close to 4.0X.
Source: ETF.com
SPY also has an abnormal overweight to technology today.
Source: ETF.com
These levels of overweighting exceed that seen even in the year 2000, right before the dotcom bust. Back then, SPY reached a height of 29.3% in technology before it all came crashing down.
Source: Seeking Alpha
So, while we did discuss the put write strategy on SPY as that is where we have the most data, we would actually not apply it on this index. We believe applying this strategy to carefully chosen value stocks has the potential to outperform. Further, by selling longer-dated puts when appropriate, we can aim to further reduce the BETA of our portfolio.
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This article was written by
Conservative Income Portfolio is designed for investors who want reliable income with the lowest volatility.
High Valuations have distorted the investing landscape and investors are poised for exceptionally low forward returns. Using cash secured puts and covered calls to harvest income off value income stocks is the best way forward. We "lock-in" high yields when volatility is high and capture multiple years of dividends in advance to reach the goal of producing 7-9% yields with the lowest volatility.
Preferred Stock Trader is Comanager of Conservative Income Portfolio and shares research and resources with author. He manages our fixed income side looking for opportunistic investments with 12% plus potential returns.
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