Let's just fast-forward to June.
All that really matters is if the Federal Reserve announces an interest-rate cut on June 12. Until then, everything that crosses the tape -- from earnings reports to economic data -- is commentary or, at best, a short-term, tactical-trading opportunity leading up to the main event.
This makes first-quarter earnings season, which is just getting under way, unusually nuanced and tricky.
If earnings reports are too good, and companies are too optimistic about the future, stocks might rally for a bit -- but the Fed might conclude that the economy is too strong to merit a rate cut, sending stocks lower. The same risk exists if economic data continue to show little sign of weakness.
The tension in the market is evident in the implied volatility of options on big-and small-stock indexes.
The SPDR S&P 500 exchange-traded fund, which tracks the largest stocks, is trading with an implied volatility of about 12%, compared with about 19% for the iShares Russell 2000 ETF, which is made of small stocks.
The volatility differential arguably telegraphs concern that the Fed might not cut rates in June, as so many investors now expect. If a June rate cut were considered a certainty, small-cap volatility would arguably be closer to that of large-cap stocks.
Instead, small-cap stock volatility is higher, reflecting the risk that a rate cut, though generally expected, might not actually happen.
The difference between large and small stocks' implied volatility is based on many factors, in particular the notion that higher rates are a burden for smaller companies, which typically borrow money at less-favorable rates than large companies.
We mention all this as a counterweight to the argument that the stock market is too quiet, and the Cboe Volatility Index, or VIX, is too low.
In our view, the stock market, as viewed from the derivatives markets, is in a state of exquisite tension that will either fall apart all at once or gradually relax when investors feel they have enough information to definitively anticipate the outcome of the Fed's June meeting.
The tension that defines the stock and options market is largely hidden -- within the futures market. VIX futures, which are used to price VIX options, are generally a few points higher than the VIX itself throughout the year. This elevated curve reinforces the same message that small-cap stocks are sending: Investors should not yet conclude that the Fed will lower rates in June.
To our thinking, the VIX -- the fear gauge that everyone likes to cite -- is reasonably priced at 14, insofar as stocks have strongly advanced this year and options pricing models largely assume the future will be like the past. As stocks rise, realized volatility edges lower, and that pulls down implied volatility, which is the essence of the VIX.
Still, the VIX is far below its long-term average of 19. In keeping with our conviction that a low VIX merits caution, a June hedge is worth considering before other investors come to a similar conclusion as ours and demand for bearish put options distorts pricing.
With the SPDR S&P 500 ETF at $518.84, investors can buy its June $500 put for about $5.43.
We choose this straightforward approach because implied volatility is low and stock prices are high, and we want to benefit from any changes without playing a complicated game of options gymnastics.
If the market weakens, and SPY is at $485 at expiration, the put is worth $15. If the Fed cuts rates in June and the hedge wasn't needed, the loss can be used to offset gains elsewhere in your portfolio.
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