Fear of a Stock Market Crash? Hedging is currently inexpensive

Particularly risk-averse investors view the current situation in the stock markets with mixed feelings. On one hand, stock markets, especially in the USA, are already highly valued, increasing the risk of corrections. On the other hand, market sentiment remains very optimistic – and "exuberant" market phases can notoriously last longer.

One way to continue benefiting from rising stock markets while avoiding significant portfolio losses due to extreme risks, known as tail risks, is to hedge the equity exposure using put options. The following explains why such hedging is currently attractive.

High Valuations in the US Stock Market

Driven by the outstanding performance of the so-called "Magnificent-7" stocks, the US stock market has yielded double-digit returns over the past year. It is now trading at record levels. This reduces the expected stock returns in the coming years, as shown in the following chart. It combines the historical annual stock return over the next ten years with the valuation level of stocks (12M-Forward P/E) since 1990.

Currently, the 12-month forward P/E for the S&P 500 is 22. From a historical perspective, the next ten years of stock returns could be modest on average. However, it should be noted that return development is usually not linear; larger corrections typically depress the annualised return over a certain period.

Another valuation perspective also urges caution. This is the so-called equity risk premium. This value shows the expected excess return of stocks over US government bonds. Currently, it is at its lowest level in more than twenty years.

For the risk of being invested in US stocks, one is compensated with a very low excess return over government bonds compared to historical standards.

Of course, high valuations or low equity risk premiums do not necessarily mean that a stock market crash is imminent. The past has shown that phases of excessive valuation can last for a long time. Also, the current situation is not comparable to the time before the bursting of the "dotcom bubble" in the early 2000s. Unlike then, today's highly valued companies have greater earnings power and higher quality. Therefore, it can make sense to remain invested in the market but protect oneself against significant price declines with hedging.

Attractive Hedging Premiums

A popular hedging strategy against a potential stock market crash is to buy one (or more) put options on the stock market with a strike price significantly below the current index value (e.g., at 90%). This protects against potential high losses. While this "out of the money" put option does not protect against smaller losses, it is cheaper than an "at the money" put option. The premium to be paid for the option depends on stock market volatility. The lower the volatility, the cheaper the option (ceteris paribus). Euphoric market phases usually coincide with low stock market volatility. Therefore, such phases are suitable for building a hedge.

Currently, one pays a premium of 2.2% for a put option on the S&P 500 with a strike of 90% and a one-year term. This is inexpensive by historical standards, as the following chart shows:

Many investors only become aware of stock risks during a market crash. However, those who want to hedge then usually have to dig deep into their pockets, as the prices for put options are typically much higher in such phases. This was observed, for example, during the financial crisis of 2008 or the Corona crisis of 2020.

Geopolitical and Economic Uncertainties

Markets are reacting positively to the election of Donald Trump as the 47th President of the USA. He wants to cut taxes and roll back regulations, which generally supports stock prices. Furthermore, it is Trump's declared goal to bring jobs back to the USA and thus further stimulate growth – keyword "America First."

However, Trump's threatened tariff policy against various countries is causing uncertainty. With tariffs, the US President aims to reduce the US trade deficit. According to economic theory, as long as a country does not increase its savings rate or reduce investments, the trade deficit does not improve. On the contrary, the new tariffs are likely to lead to an increase in the inflation rate. The announced repatriation of immigrants without residence permits to their home countries would also drive inflation. The supply of cheap labour would decrease. Provided the Fed maintains its independence from Trump, it will respond to rising inflation rates with interest rate hikes or fewer rate cuts – which would likely be detrimental to the stock markets.

Conclusion

There are several reasons why the current positive sentiment in the markets could continue for a while. On the other hand, there are significant reasons why a stock market correction or even a crash could be imminent. Those who want to protect themselves against such extreme events without reducing their stock holdings currently find favourable hedging conditions. A systematic and permanent hedging of stock market investments is also available as a fund solution.