What's the frequency, Kevin?
Kevin Warsh, the semi-new Federal Reserve chairman, is a known unknown risk factor who merits his own volatility rating. His demeanor, and his overwrought news conferences, suggest he is an unpredictable force in a job that has long been defined by predictability.
He has said he envisions a new way of central banking, though it isn't yet entirely clear what he means, even though he started in late May. When Warsh spoke to reporters after the Federal Open Market Committee raised interest rates last week for the first time since 2023, he roiled a calm market, sending equities sharply lower. They have since rebounded, chiefly for reasons attributed to 1) extraordinary corporate earnings growth, 2) softer oil prices, 3) a rebound in the Magnificent Seven stocks, and 4) renewed faith in artificial intelligence.
Warsh, however, should make investors uneasy. He is one of the few people who can move markets with words and silence. He may evolve into his Poseidon-like position, but probably not before the year's final rate-setting meetings conclude on Oct. 28 and Dec. 9. The five committees he has appointed to review the bank's operations are also expected to issue their reports, whenever that may be. It seems like an important part of the Warsh puzzle.
Until then, Warsh should be priced as the human personification of implied volatility. Even though the Cboe Volatility Index, or VIX, is slumbering around 14, the Warsh Volatility Effect is higher. Pick a number that reflects your view. He's a 20 if you think he's reasonably disruptive, or a 40 if you think he is a wild card who can trigger a recession.
We have noted that market volatility should be expected around Fed meetings and the Nov. 3 midterm elections. Nothing has changed, though the rate hike-we thought Warsh would persuade colleagues to stand down to appease President Donald Trump-reinforces our concerns.
A meaningful answer remains elusive for why stocks surged the day after the rate hike, which suggests the market's tectonic plates are shifting as investors try to understand global central bank activity and a Fed chairman who seems like a method actor.
As investors process what higher rates mean for equities, or if Republicans lose Congress, or if the Iran conflict lasts longer than expected, risk aversion seems prudent. It has been a good year so far, and the year is almost over. Risking profits that are meaningfully higher than historical annual averages is foolish.
To complement our recent hedging strategies, aggressive investors can consider a bearish ratio spread, which increases in value if stocks decline while creating an opportunity to buy stocks at lower prices.
With the State Street S&P 500 SPDR exchange-traded fund at $773.38, buy the December $765 put option and sell two December $735 puts. The strategy generates a credit of $2.10. (Puts give holders the right to sell an underlying asset at a designated price and time.)
If the ETF is at $735 at expiration, the spread's maximum profit is $32.10. Below $735, investors are obligated to buy the ETF. During the past 52 weeks, it has traded from $629.28 to $779.37.
We like ratio put spreads because hedging is expensive and requires precise timing. Selling an extra put lowers your hedging expense, and positions you to buy quality stocks during a pullback.
As we often note, investor fear is a powerful force-almost an asset class in itself-that helps long-term investors multiply returns.
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