Indexology^® Blog

The S&P 500 lost 9.2% in its second worst December on record – only behind December 1931 when the index lost 14.5%.  However, the widespread losses across sectors, styles and sizes in the broad U.S. equity market was remarkable with every major segment down in December.  Only 9 times in history has every segment of the U.S. equity market lost in a month (with all sector data starting in 1995 and style data in 1997.)   Those months were Aug. 2015, Sep. 2011, May and Jun. 2010, Jan. and Feb. 2009, Oct. 2008, and Jul. and Sep, 2002.

Not only was every segment of U.S. equities negative in December but 33 of 42 segments had their worst December ever,  For the 9 other segments, 7 recorded their 2nd worst Decembers and 2 had their 3rd worst Decembers.  Despite the December records, none of the 42 segments of the market posted their worst month ever, but the S&P MidCap 400  lost 11.5%, recording its 4th worst month ever, with the S&P 400 Health Care down 13.6%, S&P 500 Energy -12.8%, S&P 600 Consumer Staples -11.8% and S&P 600 Energy -23.6%, all recording their 3rd worst months ever.

As bad as December was, it was only partly responsible for the drawdowns experienced this year.  In fact, in most segments, December’s loss didn’t even account for half the total bloodshed.  Only 12 of 42 segments lost more than half their total drawdown in December: S&P 600 Utilities 63%, S&P 500 Real Estate 62%, S&P 400 Communication Services  62%, S&P 400 Real Estate  57%, S&P 600 Real Estate  57%, S&P 500 Health Care 56%, S&P 600 Communication Services 55%, S&P 600 Consumer Staples 55%, S&P 500 Consumer Staples 55%, S&P 400 Health Care 53%, S&P 600 Health Care 53%, and S&P 600 Financials 52%.  

Although health care and utilities declined in December for more than half their total drawdowns, they still held up relatively well for the year.  Overall, health care was the only sector with big enough early gains, especially in small caps to survive the year in positive territory.  The small caps outperforming large caps in health care can be due to deal making, increased expectations for acquisition of smaller companies, stronger innovation from smaller companies and that smaller companies may be more immune to concerns of regulatory pressures in healthcare.

That said, the S&P SmallCap 600 Health Care index still posted its worst quarter ever, losing 23.1%, due to the slowing growth of health care spending.  The S&P SmallCap 600 Industrials also logged its worst quarter ever, losing 23.5%, mainly due to a slowing economy and trade tensions.  While the S&P 500 Energy had its worst 4th quarter, losing 24.4%, it was not enough to push it into its worst year, but still only lost about half of the smaller companies in the sector.  If oil prices rise, and inflation picks up, small caps may get the benefit of the uptick since they are less hedged than the bigger energy companies.

What’s next for equities is impossible to know for sure, especially when there has only once been a December this bad.  While the year ended down 6.2% for the S&P 500, its worst in a decade, there were 22 years prior with worse returns.  In the Januaries following those 22 years, only 7 were negative, and the average return was 7.1%.  In the 22 years following the years worse than 2018, 9 were negative with an average of 1.0%, and of the 7 negative Januaries, 4 of those years ended negative in 1932, 1941, 1974 and 2002.  On average in all Januaries, small caps have lost 48 basis points while large caps gain 8 basis points and mid caps win gaining 39 basis points, and historically continue to win through the first quarter.

Though the market is hard to time, positioning for the rebound matters, especially by size and sector.  Mid-caps may do well in these first bull-market days since they are generally not as risky as smaller companies, yet have solid infrastructure but are nimble enough to take advantage of opportunities, especially overseas if the dollar drops.  Regardless of size, the financial and real estate sectors have done best on average in the first days of a new bull. Every size of these sectors develop into a bull market in the first 20 days on average after S&P 500 bottoms with large- and mid-cap financials returning nearly 28%. Even in just the first 3 days, the average returns of these segments were between 11.3% and 15.4%.

Is this time the same or different? Most of the time the markets come in cycles but there are some current issues to be focusing on now.  Despite decent consumer spending and manageable debt levels, low unemployment and wage growth and a growing economy – even if slowing, there are broader systematic risks impacting the world like slowing Chinese and European growth, trade tensions, Brexit, slowing housing and rising interest rates,

Does this describe 2018?  This perhaps?  What about this?

Let’s be frank: the markets took a bit of a beating this year.  In contrast to the tremendous performance of last year, 2018 was markedly less enjoyable or serene:

1. At the Close – the DJIA ends an ugly year on a positive note; the last session added over 260 points to finish at 23,327.46 for a daily gain of 1.15% and the best final trading session since 2012. But for the year, the Average closed down 5.63%, the worst annual performance since 2008 and only the second negative yearly return of the last decade.  The DJIA also closed out 2018 down over 13% from the high for the year; similarly, that was the worst since 2008 when the market closed nearly a full third lower (down 32.79% from that year’s high).
2. Prominent Themes – The return of volatility, the last legs(?) of a decade long bull market, tariffs and trade wars, interest rate increases and unpredictable US and global political climates.
3. New Highs – the DJIA logged 15 new highs in 2018, behind the pace of the last few years yet ahead of the annual average of 11 new highs per year since inception. In contrast, the DJIA reached more new highs in 2017 – 71 in total – than any year in history.  There have been 53 calendar years when the DJIA notched at least 1 new high and 70 when none were recorded.
4. Large Moves – Muted volatility was a major theme in 2017. But in 2018?  Yeah…no.  This year, there were 69 trading sessions when the DJIA posted a move of 1% or greater.  That performance is more volatile than historical averages:  since 1940, the annual average is ~49 one percent moves or an experience that typically occurs in about 1 of every 5 trading sessions.  In 2018, the statistic was greater than 1 in every 4 sessions.  By comparison, in 2017 a 1% move occurred in only 1 of every 25 sessions.  Similarly, the DJIA’s realized 21 day volatility ended the year at 28.51, nearly 4 times higher than the reading at the end of 2017.
5. Best & Worst Days:
   • Best Day in Point & Percent Terms – December 26 (up 1086.24 or 4.98%), when investors, heartened by positive retail numbers, drove the DJIA to its first ever 1000+ point daily gain and the best ever Christmas Eve session.
   • Worst Day in Point & Percent Terms – February 5 (down 4.60% or 1175.21), when, oddly, the charging economy led to inflation concerns and potentially resultant Federal Reserve responses. The DJIA posted its first ever single session 1000+ point decline followed 3 days later by yet another.
6. Quarterly Gain – the DJIA posted a pretty brutal return of -11.83% in Q4, the worst period since Q3 of 2011 when the European debt crisis weighed on investor sentiment and pushed the DJIA down 12.09%.
7. 10 Year Returns – since inception, the DJIA has an average 10 year return of over 83%. This year, despite the negative performance, the 10 year return is a whopping 165%.  How is that possible?  It’s because this most recent 10 year period began after the DJIA got smoked during the financial crisis:  since then, the DJIA has risen from ~8,800 to over 23,000.
8. Milestones – Two new 1000 point milestones were logged in January (25k and 26k) but the party ended shortly thereafter. This, in contrast to 2017 when 5 new 1000 point milestones (20k, 21k, 22k, 23k & 24k) were recorded.  That performance was the most active such period on record. Remember the caveat:  it’s important to note that as the DJIA gains in value each successive 1000 point milestone represents a smaller percentage gain.
9. Stock Contributions – UnitedHealth Group (UNH) was the biggest contributor to the DJIA’s advance, adding over 197 points. Boeing (BA) and Merck (MRK) were in the #2 and #3 spots respectively.  Goldman Sachs (GS) was the worst performer in 2018, responsible for bleeding nearly 600 points from the DJIA; 3M (MMM) and IBM (IBM, duh) were the second and third worst performers.   In all, fourteen stocks added to the DJIA over the last year while seventeen detracted. Yes, 14+17=31, more than the DJIA’s requisite 30 blue chip names.  But remember that General Electric (GE), the last remaining original DJIA component, was replaced by Walgreen Boots in June – we need to include GE’s performance (a detraction, by the way) to fully account for the movement of the Average.
10. Sector Contributions – the Healthcare sector was the largest contributor in 2018, followed by Telecommunications and Consumer Discretionary. In fact, those were the only 3 sectors to make positive contributions.  To the downside, Financials were the worst performer, followed by Industrials and Energy.

Here’s hoping for a better 2019.

As the year comes to a close with just two trading days left of the second worst December on record since 1931 for the S&P 500, it may be hard to remember the relatively calm rise before the volatile downturn took over.  Though there is not an official bear market yet, there was a 19.8% drop by the end of Christmas Eve that rebounded nearly 5% on the day following Christmas (Dec. 26, 2018.)  The decline can be blamed on a number of different factors including slowing economic growth in China and Europe, ongoing political uncertainty and turmoil both domestically and abroad, a softening housing market, as well as Fed tightening and businesses facing a tighter credit environment.

Now, every single sector, style and size of the market are down this month, which has only ever happened in 9 other months in history.   While 6 of those months have come in pairs, the Januaries following Decembers of years this bad are slightly positive, up 11 of 20 times, averaging 65 basis points with positive years in 13 of 20 times with an average return of 4.2%.  As discussed in this post, the first few days of a rebound is key for investors, so don’t miss it – and historically, mid-caps and small caps typically do much better in rebounds than large caps.  There are some bright spots as the economy is still growing, the labor market is tight and consumer spending is healthy with contained debt levels.

To end the year, here is a list of some of the most popular U.S. equity market topics for 2018, including the telecommunication services sector expansion into communication services, small caps, rising interest rates and the signal that warned of this near bear market.

Sectors

A First Look Inside The Communication Services Select Sector Index
Before & After The Sector Shakeup In The S&P 500 – Part 2
Before & After The Sector Shakeup In The S&P 500 – Part 1
What’s In A Sector?
Drilling Into Industries Finds What Lifts Energy Stocks With Oil
Capturing Global Market Gains Using U.S. Sectors

Small Caps

Small Cap Premium Is 5th Biggest In History
One Big Problem In July For One Small Cap Index
Big Things Come In Small Packages – Part 1
Growth Is Still Hot Only In Small Caps
There’s Nothing Equal About Equal Weight Returns

Market Downturn

Bearish Divergence May Signal Stock Market Warning
Stocks On Pace For The 6th Scariest October Ever

Interest Rates, The Dollar

3 Reasons To Love Equities When Rates Are Rising
Here’s Why Mid-Caps Matter As The Dollar Drops

Happy holidays to all and thank you for reading our Indexology Blog.  Please let us know in the comments if you have any topics you want to discuss or if you have any questions.

While many investors are concerned about the fact that benchmark indexes for major investment classes are down year-to date, more investors are using S&P 500^® options for goals related to risk management and income enhancement.

• On December 20 open interest for Cboe S&P 500 (SPX^(SM) and SPXW) options surpassed 21 million for the first time ever in its history of more than 35 years, and hit a new all-time record high of 21,424,148 contracts, and
• The Cboe S&P 500 95-10 Collar Index (CLL^SM), an index that tracks the performance of a strategy that buys SPX puts for protection and sells SPX calls for income, rose 2% in 2018 (through December 20).

CHARTS ON RECORD OPEN INTEREST FOR S&P 500 OPTIONS

The chart below shows that open interest for Cboe’s S&P 500 options rose from 1.1 million in 1993, to 16 million in July 2018, to a record 21.4 million contracts on December 20.

RECENT COMMENTS FROM TRADERS AND PORTFOLIO MANAGERS

In the past week I spoke with a number of traders and portfolio managers to inquire about their thoughts about the growth to record open interest in S&P options. The responses I heard included –

• “Higher volatility levels in recent months make the markets more attractive for options sellers who wish to generate more premium.”
• “Cash-secured put-writing has gained more mainstream acceptance”
• “There is more interest in portfolio protection and generation of income”
• “There is more trading in SPX call spreads. Look at SPX call open interest which has been beefed up by the sheer quantity of multi-legged call trades that have been trading to hedge the other tail. Millions of calls since the Sept 21st expiry!”
• “We are seeing SPX volatility sellers with some big multi-leg positions”

YEAR-TO-DATE PERFORMANCE AND MITIGATION OF LOSSES WITH CLL INDEX

The chart below shows that “traditional” key benchmark indexes for large-cap US stocks, small-cap US stocks, emerging markets stocks, Treasury bonds and commodities all fell in 2018 (through December 20), but that the Cboe CLL index rose 2% in the same time period.

The Cboe S&P 500 95-10 Collar Index (CLL) is an index designed to provide investors with insights as to how one might protect an investment in S&P 500 stocks against steep market declines. This strategy accepts a ceiling or cap on S&P 500 gains in return for a floor on S&P 500 losses. The passive collar strategy reflected by the index entails:

• Holding the stocks in the S&P 500;
• Buying three-month S&P 500 (SPX) put options to protect this S&P 500 portfolio from market decreases; and
• Selling one-month S&P 500 (SPX) call options to help finance the cost of the put options.

The term “95-110” is used to describe the CLL Index because (1) the three-month put options are purchased at a strike price that is about 95 percent of the value of the S&P 500 at the time of the purchase (in other words, the puts are about five percent out-of-the-money), and (2) the one-month call options are written at a strike price that is about 110 percent of the value of the S&P 500 at the time of the sale (in other words, the calls are about ten percent out-of-the-money). The starting and base date for CLL Index is June 30, 1986, at which it was priced at 100. The CLL Index is designed to be a valuable resource for investors who want to explore ways to manage their portfolio risk in bear markets.

SPX SKEW CHART SHOWS HIGHER IMPLIED VOLATILITY FOR OTM PUTS

The volatility skew chart below shows estimates for implied volatility (y-axis) for S&P 500 options for the Monday, Wednesday and Friday expirations (dates in legend at left) and at various strike prices (in x-axis). Note that the implied volatility estimates for many of the out-of-the-money (OTM) S&P 500 put options range from 22 to 110, while the implied volatility estimates for many of the S&P 500 call options range from 15 to 40, a much lower range. One could infer from this chart that there probably is quite a bit of strong demand for downside protection with use of the OTM puts. In addition, in recent years many investors have seen the performance of the Cboe S&P 500 PutWrite Index (PUT) and become more comfortable with the idea of selling cash-secured puts on the S&P 500.

MORE INFORMATION

To learn more about ways in which index options and volatility products can be used in portfolio management, please visit these links –

• www.cboe.com/SPX S&P 500 index options
• www.cboe.com/benchmarks Cboe’s strategy benchmark indexes, and related research papers by Wilshire and other firms.
• www.cboe.com/funds Funds that use options
• www.cboe.com/strategies Options strategies
• www.cboe.com/education Options education
• www.cboeRMC.com  Cboe Risk Management Conferences in Europe, Asia and the U.S.

++++++++++++++++++++++++++

Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options (ODD). Copies of the ODD are available from your broker or from The Options Clearing Corporation, 125 S. Franklin Street, Suite 1200, Chicago, IL 60606. The information in this blog is provided solely for general education and information purposes and therefore should not be considered complete, precise, or current.  Many of the matters discussed are subject to detailed rules, regulations, and statutory provisions which should be referred to for additional detail and are subject to changes that may not be reflected in these materials. No statement within this material should be construed as a recommendation to buy or sell a security or to provide investment advice.  The Cboe S&P 500 BuyWrite Index (BXM^SM), BXMD^SM Index, PUT^SM Index, and CLL^SM Index are designed to hypothetical strategies that invest in index options and/or VIX futures Like many passive benchmarks, the Indexes do not take into account significant factors such as transaction costs and taxes. Transaction costs and taxes for an options-based strategy could be significantly higher than transaction costs for a passive strategy of buying-and-holding stocks. Investors attempting to replicate the Indexes should discuss with their brokers possible timing and liquidity issues. Past performance does not guarantee future results. These materials contain comparisons, assertions, and conclusions regarding the performance of indexes based on backtesting, i.e., calculations of how the indexes might have performed in the past if they had existed. Backtested performance information is purely hypothetical and is provided in this document solely for informational purposes. The methodology of the Indexes is owned by Cboe, Incorporated (Cboe) may be covered by one or more patents or pending patent applications. S&P®, and S&P 500® are registered trademarks of Standard & Poor’s Financial Services, LLC and are licensed for use by Cboe, Incorporated (Cboe) and Cboe Futures Exchange, LLC (CFE). Cboe’s financial products based on S&P indices are not sponsored, endorsed, sold or promoted by S&P and S&P makes no representation regarding the advisability of investing in such products. Cboe Volatility Index®, VIX®, Cboe® and Chicago Board Options Exchange® are registered trademarks of Cboe. All other trademarks and service marks are the property of their respective owners.

“Change is the only constant,” as quoted by Heraclitus, a Greek philosopher.

The recent assembly election results have reiterated this. We saw a leadership change at the Reserve Bank of India (RBI), with Mr. Shaktikanta Das’s appointment as the new RBI Governor, following Mr. Urjit Patel’s resignation.

The financial markets have also had their fair share of ups and downs. In 2018, India’s equity market witnessed a low when the S&P BSE SENSEX dropped to 32,596 (price return index level as of March 23, 2018), but also saw a high of 38,896 (price return index level as of Aug. 28, 2018)—a fluctuation of 6,300 points and a 19% variation over the year. However, this year the index reached record highs compared with the past 10 years. The S&P BSE SENSEX first crossed the 10,000 mark on Dec. 18, 2008, the 20,000 mark on Sept. 21, 2010, and finally the 30,000 mark on April 26, 2017. The fixed income market was no exception, with the 10-year Government Bond yields crossing 8% multiple times in September and October 2018. There has a been an ongoing discussion on the broadening of the Indian debt market, which faces challenges in terms of liquidity, innovation, investor awareness, and participation.

Other changes introduced by the Securities and Exchange Board of India (SEBI) were style and size definitions for mutual funds, as well as consolidation of  mutual fund schemes to a single offering in each style category in order to create a standardization for the market and its investors. SEBI also advised mutual funds to adopt total return indices (TRI) to benchmark their schemes, effective as of Feb. 1, 2018. This would enable investors to compare the appropriate index with the scheme’s performance.

With the constantly shifting investment landscape, some changes have been significant. The endless discussion around the active vs. passive debate has also progressed. More and more market participants have aligned with the fact that a passive investment strategy can be part of the overall investment goal achievement. A core satellite strategy easily encompasses both active and passive styles. The SPIVA^® India Mid-Year 2018 results revealed how large-cap funds in India have been under performing the benchmark, the S&P BSE 100. The index outperformed the fund category by over 87% in the 1-year period, 78% in the 3-year period, 48% in the 5-year period, and 62% in the 10-year period. Active fund managers have been waking up to the fact that large-cap passive investing is a strategy potentially worth evaluating.

Source: S&P Dow Jones Indices LLC, Morningstar, and Association of Mutual Funds in India. Data as of June 30, 2018. Past performance is no guarantee of future results. Table is provided for illustrative purposes and reflects hypothetical historical performance. The S&P BSE 400 MidSmallCap Index was launched on Nov. 30, 2017. The S&P BSE India Government Bond Index was launched on Dec. 31, 2013. The S&P BSE India Bond Index was launched on March 12, 2014. .

Furthermore, government bodies like the Employee Provident Fund Organization (EPFO) and the Department of Investment and Public Asset Management (DIPAM) have supported the passive style of investing with the promotion of exchange-traded funds (ETFs). EPFO’s allocation to equity ETFs stood at 15% of its investible surplus, which is over INR 40,000 crores as of September 2018. Furthermore, the EPFO has been developing software that will allow them to credit the ETFs to subscriber accounts, thereby empowering subscribers for further transaction. DIPAM, on the other hand, used the ETF vehicle successively to liquidate holdings in public sector undertakings. In 2018, they had follow on offers for the ETFs, the S&P BSE BHARAT 22 ETF and the CPSE ETF, both of which were oversubscribed. Their new initiative for a debt ETF could be a strong innovation to promote passive style of investing in the fixed income space.

Passive investing is now getting more emphasis, and as index-based investing offers diversification, transparency, and liquidity, there are positive signals that with growing investor education and awareness, India could witness more growth in the days to come.

References:

• Categorization and Rationalization of Mutual Fund Schemes, SEBI Circular SEBI/HO/IMD/DF3/CIR/P/2017/114, Oct. 6, 2017.
• Benchmarking of Scheme’s performance to Total Return Index, SEBI Circular SEBI/HO/IMD/DF3/CIR/P/2018/04, Jan. 4, 2018.
• September 30 Economic times Wealth