With the end of the COVID-19 pandemic hopefully in sight, the options market is signaling that the return to “normal” could prompt the reversal of long-standing market trends, while new digital habits are likely here to stay.

Key Takeaways

• A normalization of the global economy in 2021 could lead to the reversal of some decade-long market trends: value stocks potentially outperforming growth, non-U.S. equities taking the lead over U.S. stocks and interest rates rising.
• Still, uncertainty remains about the pandemic’s trajectory, and acute stress in small businesses could lead to higher joblessness, weighing on economic growth.
• During the pandemic, investors moved a sizable amount of money into cash. One key indicator for the direction of markets in 2021 will be whether that cash gets redeployed into riskier assets.

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What is the options market signaling in terms of key economic and market trends for 2021?

Ashwin Alankar: We emphasize the importance of looking at data, and based on the large amounts of big data that we look at – particularly specific attention to option price data – it is all telling us that a key structural theme that will likely unfold in 2021 is a return to quote, “normal.” If you look back at 2020, the successful investor embraced the power of the central bank, which led to a massive rally in long-duration assets as central banks cut interest rates to zero around the world. The friend of the successful investor in 2020 was most definitely the central bank. And in 2021, we believe the friend of the successful investor will be science. It will be the science behind the COVID vaccine.

Where do you see the biggest market opportunities?

The areas where we see the biggest and the greatest opportunities conforming to what our signals are telling us is that cyclical and value sectors – such as energy, financials, materials – will lead the markets forward, not big tech. Non-U.S. equities will lead the markets forward, not U.S. equities. And we will likely see interest rates rise, not fall. So, in effect, many of the trends that have characterized the markets over the last decade may be on the cusp of reversing, all thanks to the science behind the COVID vaccine, which will bring normalcy or a sense of normalcy back to our lives.

What should investors consider as the global economy returns to “normal?”

While we do see the light at the end of the pandemic tunnel, we really, right now, do not have a great idea of how long this tunnel is. And if the tunnel is too long, bankruptcy becomes a real risk. If distributing and deploying the vaccine to the number of people needed to achieve herd immunity faces hurdles, takes longer than expected, many companies – not the Microsoft or the Walmarts of the world – but many of the small businesses and enterprises, which really are the growth engines behind most countries, could face bankruptcies, which will then have a severe negative domino effect on economic activity as unemployment rises.

Staying with cyclical names with strong balance sheets with access to financing is important. And at the same time, habits are formed during the pandemic, and these habits are here to stay. The new normal, or the normal that will return, won’t be exactly the same as the pre-pandemic normal. Doing things remotely has worked out surprisingly well. For example, business travel will likely be less active, commercial real estate likely less buoyant. Many have experienced the joys of cooking at home during the pandemic, which could hamper restaurant activity. During the pandemic, the digital ecosystem has brought in hundreds of millions of new and more active customers and these customers are not leaving anytime soon. So, these are the risks that will likely accompany playing the investment theme of the structural reopening of economies. But our key investment thesis going into 2021 is the successful investor will position their portfolios to benefit from the reopening of economies.

Which market indicators are you watching closely?

One particular set of data, which I think is going to be quite valuable to look at in ‘21 to understand where the markets are headed and at what speed, is looking at the amount of cash that’s sitting on the sidelines. As the pandemic unfolded, as fears increased in 2020 on the impact that the virus may have on economies around the world, cash balances hit historical records. Of the $1.5 trillion to $2 trillion that went into money market accounts over a short two- to three-week span in March, about a half a trillion, or $500 billion, has left and has moved back into the markets. As you see these cash balances continuing to fall, that’s a very encouraging sign that institutions, that retail investors more broadly, are comfortable taking more risk. And as people get more comfortable taking more risk, as fears start to subside, as uncertainty starts to dissipate, risky assets should benefit.

What other concerns should investors have going into 2021?

I’m often asked what is the key tail risk that I’m worried about going forward, and in this case, the key tail risk is not a drawdown event, but rather it is a melt-up event. I do think you could see the vaccine deployed faster than expected. I do think you could see people less averse to taking the vaccine than expected. And all of this sets in motion a further melt-up in risky assets. This is a risk that could potentially be very painful if investors, both institutions and retail, sit on more cash, sit with more conservative portfolios than they usually do.

 

Our team arrives at its outlook using options market prices to infer expected tail gains (ETG) and expected tail losses (ETL) for each asset class. The ratio of these two (ETG/ETL) provides signals about the risk-adjusted attractiveness of each asset class. We view this ratio as a “Tail-Based Sharpe Ratio.”

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