Earnings downgrades create short-term risks to the downside
However, a passing of the worst part of the credit crunch does not mean that we have passed the worst part of the economic and earnings cycle. We continue to expect earnings disappointments to drive earnings revisions lower. Higher oil prices are an additional risk to margins in an environment where the growth/inflation mix is deteriorating, raising the short term risk to the downside. Experience in the early 1980s and 1990s suggests that markets can be ârange-boundâ for prolonged periods around profit downturns. We do not expect the market to break out of the trading range on the upside before the end of this year, roughly six months before a likely acceleration of earnings growth.
We recommend hedging the downside risks
Implied volatility is down dramatically over the past month, creating an opportunity to hedge. Our Options team suggests buying digital puts which pay off if the Euro Stoxx 50 closes below 3,700 in three months. These offer a better return than vanilla puts if the market falls within our range