HomeMost PopularPrepare for a Probable Major Market Correction: The Outlook for SPY

Prepare for a Probable Major Market Correction: The Outlook for SPY

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Despite the Federal Reserve’s aggressive approach to raising interest rates, the SPDR S&P 500 ETF Trust (NYSEARCA: SPY) has managed to deliver double-digit returns over the past year. However, investors need to question if this resilience is justified or if it’s just a last hurrah before a potential crash. In this article, we will examine the current valuation, interest rates, Federal Reserve policy, and historical returns to assess the likelihood of a major negative catalyst for SPY within the next 12 months.

Current Valuation: A Balanced Picture

The 14% total return achieved by SPY over the past year aligns with the upward trend in forward earnings per share (EPS) estimates for the S&P 500. As forward estimates have increased by over 50% since the beginning of the year, it has driven down forward price-to-earnings (P/E) multiples. With a forward P/E around 19, the recent valuation appears to be in line with historical averages, indicating fair value.

Normalized Interest Rates: Cause for Concern

Recent elevated yields on the 10-year treasury bond and the Federal Reserve’s faster pace of rate hikes have raised fears in the equity markets. The yield on the 10-year treasury is currently at levels not seen since before the Great Recession. Additionally, the effective Federal Funds rate has spiked, reaching levels comparable to those seen in 2006-2007. Previous rate hike cycles followed by rate cuts have often preceded recessions. This raises questions about the sustainability of the current rate hold period and the potential timing of the next rate cut cycle.

Deflating the Ballooned Fed Balance Sheet

While interest rates stabilize, the Federal Reserve continues to reduce its balance sheet, adding pressure to the markets. Although the Fed has made progress in reducing its assets over the past year, the overall size of the balance sheet remains significantly larger than pre-financial crisis levels. The unwinding process may intensify market volatility if not managed effectively.

Historical Returns Set to Normalize

The massive increase in the Fed’s balance sheet since the Great Financial Crisis has influenced market returns. Buying SPY after the crisis has consistently delivered above-average returns. However, when comparing returns over the last 20 years, the inflated returns seem concentrated after the crisis. It is crucial to recognize that historic easy monetary policies no longer provide tailwinds for future returns. As returns normalize, investors need to consider potential downside risks and adjust their expectations accordingly.

Hedging the Downside Risk

Investors concerned about potential market volatility can consider strategies to hedge against downside risk. One approach is creating a buffered position using LEAPS options. These options provide downside protection for a set amount of losses, allowing investors to participate in price appreciation while limiting potential downside risk. For example, implementing a bear put spread and selling a short call option on SPY can help protect against significant market declines while capping potential gains.

Conclusion: Prudent Portfolio Protection is Key

As the era of easy monetary policy comes to an end, investors should adjust their expectations for future market returns. The recent resilience in SPY does not guarantee continued success, and there are warning signs of a potential major correction. It is prudent to take steps to protect portfolios from downside risks and consider alternative strategies like the buffered LEAPS options approach. By doing so, investors can ensure they are prepared for potential market turbulence without sacrificing the opportunity for reasonable returns.

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