Key takeaways:
- With options markets hinting at a low risk of recession and limited concerns regarding valuations, the backdrop for global equities, led by large-cap U.S. stocks, appears sanguine heading into 2026.
- Options signals indicate a favorable environment for global bonds as participants in risk-transfer markets do not anticipate a rise in interest rates that is typically associated with accelerating inflation.
- Low correlations between individual stocks reveal little systemic risk is priced into markets; should non-diversifiable risk revert to historical averages, investors could demand a higher risk premium which, in turn, may lead to valuation compression.
IMPORTANT INFORMATION
Equity securities are subject to risks including market risk. Returns will fluctuate in response to issuer, political and economic developments.
Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
Options (calls and puts) involve risks. Option trading can be speculative in nature and carries a substantial risk of loss.
Definitions
Correlation measures the degree to which two variables move in relation to each other. A value of 1.0 implies movement in parallel, -1.0 implies movement in opposite directions, and 0.0 implies no relationship.
Idiosyncratic risks are factors that are specific to a particular company and have little or no correlation with market risk.
Price-to-Earnings (P/E) Ratio measures share price compared to earnings per share for a stock or stocks in a portfolio.
A risk premium represents the extra return expected from an investment beyond the risk-free rate; it compensates investors for the additional risk they undertake.
Systemic risk is the possibility that a company-level event could destabilize or collapse an entire industry or economy.
View transcript
What I want to do is share with you an outlook of the capital markets from a perspective which is quite unique, from a perspective that we’re typically not accustomed to, which is looking at what the option markets are telling us about risk going forward.
Why the option market? The option market is nothing more than an insurance market. And what we know about insurance prices is, insurance prices tell us everything about risk. So, from the prices of options, we can exactly calculate an estimate of not just downside risk to an asset class such as equities, but also the upside potential to an asset class such as fixed income. And these estimates are based on the collective intelligence, the collective wisdom, of the hundreds of thousands of people who buy and sell options every single day.
Based on these crowdsources pieces of information, the option market, and this is the good news, is not indicating any worries or fears of any strong dislocation which could cause a sharp drawdown in global equities coming into the near year and over the medium and short term that ensues. The option market is not afraid of, or isn’t assigning, a high probability of recessionary risk. And it’s not assigning a high probability of a so-called irrational bubble popping. Within equities, we’re seeing U.S. large-cap equities leading the pack going forward, though that’s not to say non-U.S. equities look unattractive; they just look marginally less attractive in terms of their risk premium relative to large-cap U.S. equities.
The biggest risk to this calm scenario or this relative steady as you go scenario in the equity markets, in our opinion, is a second bout of inflation. So, where can we get information from the option markets on whether inflation risk is high or low? Let’s look at the options that trade on fixed income, and options that trade on fixed income are indicating to us the risk of inflation is quite low. The option markets are not assigning a high probability that interest rates will rise. That’s true here in the U.S. That’s true outside of the U.S. So, this fear of a second round of inflation, whether it’s U.S.-centric inflation or global inflation, is just not supported by what the option market believes are the key risks going forward.
We can corroborate the sanguine markets that we see in fixed income, which indicate to us inflation is quite contained, by looking at what option markets are pricing in terms of risk to precious metals, such as gold or silver, and even real assets such as oil or natural gas. And the same storyline unfolds. Once again, the option market does not see heading into the new year, and in the short period of time as the new year unfolds, [that] there are large risks either to the downside nor large upside potential opportunities within the real asset markets.
Steady as you go is not a bad thing. It allows one to stay invested. It allows one to source risk premium in a stable way without risking, as I said before, suffering a large drawdown, which can compromise your ability to compound wealth over time. So the market, option markets, are telling us excitement is probably not something you’re going to see in the new year, but a boring ride is still a pretty good ride.
One signal which does have us worried is the amount of systemic risk the markets are pricing currently. One way you can measure the level of systemic risk in the system is by looking at an index or a metric called the implied correlation. So, what level of correlation is the market assigning to stocks, for example, in the S&P 500? That correlation level today is very, very, very low, implying It’s a market of stocks, not a stock market. So the market is telling us there’s a lot of idiosyncratic risk in the system, very little systemic risk in the system. But at some point, systemic risk will come into the system. These implied correlations, as a result, will increase. And when they increase, P/E ratios will compress. Risk premiums will widen. When PE ratios compress and risk premiums widen, because there’s more systemic risk in the system, asset prices fall. So we’re paying a lot of attention to these implied correlation numbers. We’re paying a lot of attention to the level of systemic versus idiosyncratic risk that the market is pricing in the system today.
