Is a bear market on the horizon for S&P 500 ETFs?

Jun 3rd, 2016 | By | Category: Equities

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The S&P 500 Index, one of the most widely followed indices in the world and a bellwether for the US economy, has recorded a turbulent start to the year, prompting market watchers to believe the index is poised to suffer a sharp decline.

Is a bear market on the horizon for S&P 500 ETFs?

UK investors looking to profit from a potential bear market in the S&P 500 Index may consider the Boost S&P 500 3x Short Daily ETP (3USS), which provides triple the inverse performance of the S&P 500 ETF, or db X-tracker’s S&P 500 Inverse Daily UCITS ETF (XSPD), which provides the daily inverse return of the S&P 500.

The index, which serves as a reference for several hugely popular exchange-traded funds including the SPDR S&P 500 ETF (SPY) – the most actively traded and largest ETF (by assets under management) in the world – has dropped 10.5% from its opening value this year of 2044 to its lowest point YTD of 1829 on 11th Feb. Despite a brief recovery in the market – where it gained 14.6% from its February low to 31 May 2016 – investors who endured the ride would still have only netted a 2.6% increase in capital value.

While such volatility is perhaps unusual, many believe the index may be poised to experience further shocks, referring to various fundamental and technical factors. Several factors have been highlighted as key systemic risks faced by the market this year that may induce the S&P 500 to enter a bear market.

Technically a bear market has occurred when the prices of securities have fallen 20% or more in multiple broad market indices such as the Dow Jones Industrial Average or the S&P 500 Index over a minimum of two months. Bear markets tend to be self-sustaining as investors, anticipating losses in a bear market, engage in large selling activity which further fuels the pessimistic outlook.

Most recently the FTSE 100 Index, the premier benchmark for UK-listed large-cap equities, experienced a bear market in November last year when it fell to 5,537 from a peak of 7,104 in April. However, this bear market was short-lived and the index recovered to hit 6,245  on 31 May 2016.

In the US it has been in excess of seven years since the end of the last bear market in the S&P 500, making the current run between bear markets the third longest on record in US history. The second longest on record ran in the 1920s and was ended by the worst stock market crash on record, while the longest stretch ran from 1990-2000 and ended in the bursting of the dot-com bubble.

Perhaps also worryingly, the VIX Index, which gauges expected volatility in the S&P 500 Index options market, rose 4.1% to 15.82 on 23 May 2016. This was the index’s fourth advance in five days. Compared to a month earlier, the so-called fear index has advanced 15%, although it still remains below its historic average.

Furthermore, according to Bloomberg, the price-to-earnings ratio for the S&P 500 is 24.0x as of 27 May 2016. This is significantly above the historical mean ratio of 15.6x and the median ratio of 14.6x (data taken between 1917 and 2009). The cyclically-adjusted price-to-earnings ratio recorded a most recent value for May of 26.1x, also significantly higher than its long-term average of 16.7x. According to these fundamental metrics, the S&P 500 is significantly overvalued.

Such fundamental and technical analysis may suggest that the S&P 500 is poised to make a correction. Analysts have highlighted several potential events which may act as such a catalyst to a devaluation including interference by the Chinese governments in their currency markets, and Britain’s exit from the EU.

The market received a taste in 2015 of the potential consequences of a surprise devaluation of the Chinese yuan. Some of the worst hit companies included miners as well as retailers with significant exposure to Chinese buyers. Perhaps more significantly though is the uncertainty such a move might bring to the future course of the Chinese economy and the Asia Pacific region in general, especially if the move is responded to with devaluations of the currencies of neighbouring countries.

With the British referendum looming ahead, and polls indicating the vote could go either way, Brexit risks to the market are becoming increasingly important to investors. According to Bank of America research, almost 9% of corporate America’s global foreign affiliate profit has come from the UK. The decision to leave the EU may squeeze the earnings of several affiliates that have strategically located themselves in the UK to better access the European single market. Such global effects are likely to affect large multi-national companies in the US, a large proportion of which are found in the S&P 500.

Investors who believe the S&P 500 is standing at the precipice of a bear market may wish to consider the following ETFs as means to protect portfolio wealth or tactically position to benefit from a crash should one occur.

The Boost S&P 500 3x Short Daily ETP (3USS) provides triple the inverse performance of the S&P 500. Its total expense ratio (TER) is 0.80%. Additionally, the db x-tracker S&P 500 Inverse Daily UCITS ETF (XSPD) provides the daily inverse return of the index. TER – 0.50%.

US investors may wish to consider the ProShares Short S&P500 ETF (SH) which provides the inverse return of the index. TER – 0.90%. The ProShares UltraShort S&P 500 ETF (SDS) provides double the inverse performance of the index. TER – 0.91%.

Investors may also wish to consider ETFs which track the VIX futures market; these funds profit from a spike in expected volatility in the S&P 500. These include the Boost S&P 500 VIX Short-Term Futures 2.25x Leverage Daily ETP (VIXL) which provides 2.25 times the performance of a daily rolling long position in first and second month VIX futures contracts. TER – 0.99%.

The two largest VIX-related ETPs for US investors by assets under management are the iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX), and the ProShares Short-Term Futures ETF (NYSE: VIXY) which have over $1.4bn and $268m in AUM respectively. The funds offer exposure to a daily rolling long position in short term VIX futures contracts. Total expense ratios of 0.89% and 0.85% respectively apply.

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