By Steven M Sears
Dec. 10, 2020
Stock prices have reached what looks like a permanently high plateau. Economist Irving Fisher said that just before the Crash of 1929. But this time is different. Really.
Despite the Covid-19 pandemic entering a more dangerous phase, with Washington still arguing over economic stimulus legislation, the S&P 500 index is trading near its highest levels ever. The options market’s fear gauge, the Cboe Volatility Index, is around 20, suggesting that sophisticated investors are confident about the stock market’s near-term future.
This widespread embrace of risk might seem surprising. But now, unlike in those halcyon days before the crash, policy makers have the benefit of history. The Federal Reserve’s monetary policy is designed to support banks, inflate stock prices, and suppress options volatility. Hence, we can assert with confidence that stocks will almost always go higher and higher for the foreseeable future.
Should monetary policy have its limits because, say, interest rates are near zero, Congress will help stocks. The government’s fiscal policy, especially when faced with Covid-19 pandemic weakness, might be designed to stimulate the economy, but it really helps stock prices the most.
The stock market, as we all know, is a discounting mechanism. It cares about what happens in the future—not the past. We know the future holds a Covid-19 vaccine, and thus we will soon be living and investing in the best of all possible worlds. Covid-19 may be morphing into an even more dangerous crisis, but this is a great time for stocks.
The traditional chasm between Main Street and Wall Street has seemingly disappeared. The masses are no longer asses. They often have been 100% correct to buy stocks, buy call options, and sell put options. Tomorrow’s prices have been invariably higher, and their bullish prancing has been profitable. The so-called smart money, once dismissive of dumb money, now tracks what they do—and trades with them.
It apparently no longer matters that retail investors have historically done the wrong thing at the wrong time. Their reputation for idiocy is so prevalent that options dealers historically have not even hedged retail positions.
But something has changed. The Street now trades with the little guy rather than doing the exact opposite.
Without doubt, these are unusual times, and we should remember the lessons of the past.
It is precisely during these moments that investors should think about what they will do should the unexpected happen and the markets tumble.
If you believe that stocks can only rally higher because the game is rigged in Wall Street’s favor—and many people think just that—you’re likely delusional. Something invariably happens when everyone is feeling sanguine and their brokerage statements are flush with profits, something that upsets the consensus view.
In anticipation of that day—and it is impossible to know when it will occur—assemble a list of potential long-term positions to buy should short-term volatility ever seriously knock prices lower.
Use the half-and-half strategy. Buy half as much stock as planned and sell the equivalent number of puts at a time when the fear premium will be elevated. Sell five puts, for example, and buy 500 shares of stocks in the heat of a decline.
If you are ready to take advantage of fear—and a scary day will come—you may just be able to steer your own portfolio to a higher plateau regardless of what happens to the market.