The period of low equity volatility may be coming to an end
Stocks have been flying the flag
The S&P 500 enters Friday's session having just registered its 18th record closing high of the year.
Goldman Sachs recognizes the main drivers behind the current rally. In a note published Thursday, Goldman researchers Christian Mueller-Glissmann and Andrea Ferrari, cite a strong U.S. corporate earnings season (boosted by AI capital expenditure), and more dovish Federal Reserve expectations.
There's been a further compression of the risk premium - the extra return equity investors demand for holding stocks - and damped volatility. The Cboe Volatility index VIX this week fell below 14.5, its lowest reading since December.
But now the Goldman team is wary, noting that compared with previous periods of low volatility there is a "less friendly" asymmetry to the stock market.
"The risk of a large rally is comparably low, as is common in low vol regimes because the largest rallies tend to occur during recoveries, but the equity drawdown probability is elevated and has increased recently," they say.
They point out the S&P 500 SPX has been boosted by valuation expansion, while credit spreads have tightened markedly, suggesting investors may not be adequately pricing in the risk of the economic damage - slower growth and higher inflation - caused by increased tariffs.
And the tariff uncertainty may also not deliver those hoped-for Fed rate cuts (Thursday's producer prices shock spoke to that concern), while geopolitical risks also linger, Goldman notes.
The Goldman team has looked at equity pullbacks in different volatility and growth scenarios and produced an S&P 500 drawdown probability index.
Source: Goldman Sachs
It currently shows that the chances of an S&P 500 pullback have started to become elevated like they did around Trump's "Liberation Day" tariff reveal in April.
"In the past few weeks, high and rising valuations again contributed to higher equity drawdown risk but also worsening business cycle momentum due to weaker labor market data.," says Goldman.
The bank's economists reckon that U.S. growth is likely to remain weak in the second half of the year. That may mean there is help for markets from more Fed easing, but it's likely to be accompanied by more equity volatility.
With all this in mind, the Goldman team says their asset allocation remains "tactically neutral", which means overweight cash, neutral on equities/credit/bonds and underweight commodities.
They suggest using currently cheap put spreads to hedge against a decline in equities. A put spread is an option strategy where a trader seeks to make a net profit from a fall in the underlying asset price, but at a reduced cost.
Goldman also ran a screen for downside and upside hedges in equities for the next three months, based on on their average return over the past 10 years versus the current option price.
It suggests put options on selective emerging market and European equities, including Brazil's Bovespa BR:BVSP, India's Nifty 50 IN:NIFTY50 and China's CSI 300 XX:000300. Goldman adds that: "[C]alls on S&P 500 equal weight RSP in particular could benefit from a broadening of the rally out of mega-cap tech stocks."
The market
U.S. stock-index futures (ES00) (YM00) (NQ00) are mixed as a jump in UnitedHealth stock adds about 200 points to Dow. Benchmark Treasury yields BX:TMUBMUSD10Y are steady, the dollar index DXY is down, while oil prices (CL.1) slip and gold futures (GC00) are trading around $3,387 an ounce.
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The buzz
U.S. economic data due on Friday include retail sales for July, alongside import prices for the same month, both released at 8:30 a.m. Eastern.
The preliminary reading on U.S. consumer sentiment for August is published at 10 a.m.
U.S. President Donald Trump will meet Russia President Vladimir Putin in Anchorage, Alaska on Friday.
Shares of UnitedHealth (UNH) and D.R. Horton (DHI) are jumping after Warren Buffet's Berkshire Hathaway took new positions in the companies, according to a filing late Thursday. Other major investors including David Tepper and Michael Burry also revealed UnitedHealth stakes.
Applied Materials shares (AMAT) are sliding after the semiconductor-equipment maker forecast a fall in revenue and profit in the current quarter.
Intel shares (INTC) are continuing to rally on reports the U.S. government is considering taking a stake in the chipmaker.
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-Jamie Chisholm
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