‘Off the Charts’ Sharpe Ratio Could Signal Time for Caution in 2018

The most common financial measure that captures the extent to which return is rewarded for risk in the equity market is the Sharpe ratio, introduced decades ago by Nobel prize-winning financial economist William Sharpe. This measure looks at returns relative to risk (standard deviation). It isolates the returns earned from taking risk by subtracting from the S&P 500 return the returns of a “risk-free” investment in that same period. For most investment strategies evaluated over long periods, perhaps five to 10 years, a Sharpe ratio of 1.0 is considered to be strong performance.

We can see Sharpe ratios for each of the last 30 years. With a Sharpe ratio over 3.0, 2017 stands out as unusual in the history of U.S. equity markets. The average calendar-year Sharpe ratio over the last three decades was 0.82. The only recent year that even came close to 2017 was 2013, when the S&P 500 delivered a 34.4% return with a standard deviation of 11.05%, below average but not nearly as low as 2017.

This chart shows the Sharpe ratios for each of the last 30 years:

What Can We Expect in 2018?

This year, we’re not likely to see a repeat of the outstanding returns relative to risk like we had in 2017. Something has to give. Risk will likely be higher and return lower. The good news is that just because the S&P 500 had very high returns in 2017 does not mean that the next year will deliver below-average returns. If we look at the very high return years of 1995, 1997, 2003, 2009 and 2013, we see that returns for the following calendar years were lower, but still solid. That being said, investors should be prepared for more volatility to earn those returns.

Strategies consistent with a more moderate return and higher-risk U.S. equity environment would be those that have a stronger focus on factors such as quality, dividend growth, and earnings growth combined with value, and that favor lower volatility stocks. Other strategies to consider are those that look to boost income by capturing some of the higher volatility anticipated in 2018 through the sale of options. These options strategies include ones that compensate investors for committing to cap some portion of upside returns (covered-call writing) or to buy equity exposure at lower prices (collateralized put writing). Short-term option premiums tend to adapt quickly to changing volatility of the underlying security or index, so the premiums for covered-call and put selling should be higher as risk moves up.