By Mark Bern, CFA
There are several ways to hedge against a major correction
in stocks. I will provide a little
explanation here on the four strategies that I sometimes use, depending on
where the market is in its cycle. For
more elaboration you may need to read some of my older articles on Seeking
Alpha.
Using Put Options
My favorite method of hedging is to buy put options on
stocks that tend to perform the worst during recessions. I have written extensively, including a
series on the subject that is still in progress. But I only use this method when I believe we
are nearing a top in the markets based upon several factors such as weak
internals, inverting of the yield curve, or a lack of momentum in the markets
with extremely high valuations (to name a few).
I try to identify companies in industries that tend to fall
more precipitously that the market in general during recessions, such as travel
related, industrial or consumer discretionary businesses. I sift through those companies to identify
the ones that have fallen the most during the last two recessions. Generally, when the market went down by 50%
these companies fell by 66% or more (some by more than 90%) from cycle
highs.
Next I eliminate those that have improved fundamentals since
before the last recession, such as reduced debt levels or increased
margins. What is left are those that I
consider candidates to buy puts options on in, and only if, the potential for
profit from a trade meets my personal requirements. I generally do not enter into a position
unless I believe it has the potential to return at least 1,000% in a bear
market pull back of 30% or more. I also
like maturities of six to nine months to give the market enough time to fall
far enough that much, if not all, of the potential is attainable.
I use out-of-the-money put options to keep the cost low and
do not exceed using 2% of my portfolio in any given year to implement this
strategy. The key is that it only takes
one or two of the companies to have a really bad earnings report for me to
recoup the total cost of my hedges for the year. When/if that happens (and it has happened
often for me) my hedging cost fall to zero, or at least close to it.
I had been hedging using this strategy from 2014 and well
into 2016. But when I saw the
possibility of an upset in the elections late in 2016 I considered the
possibility that the economy could actually improve and so I stopped
hedging. I am glad that I made that
decision, perhaps prematurely, but it has worked out well so far. I will deploy hedges again once I begin to
see the signs of a potential economic slowdown on the horizon.
This strategy works best (costs the least) when the market
participants are still optimistic about the next few months because the
premiums I pay for the puts are less.
When the market begins to fall the premiums rise making the strategy
more expensive.
Of course, there are other ways to use put options in a
hedging strategy but I do not recommend them personally because the cost is
usually much higher. And, of course, we
don’t know whether the hedge will be necessary or if it will expire worthless,
so the less money we commit to it usually the more efficient it can be.
Using Inverse ETFs
(Exchange Traded Funds)
I want to start this section by reminding people that a
leveraged inverse ETF will always (ALWAYS) decay in value (price) unless the
market falls for an extended period. If
the market falls then rises and then repeats, creating a range-bound market,
the leveraged inverse ETF will decay.
Look at the long-term charts for any of them and it will become
obvious. Every few years these
instruments require a reverse split to bring the price back up to a reasonable
level. So, buying and holding a
leveraged inverse ETF is a bad option unless the market is in a sustained free
fall. Even then it is best to not stay
in a leveraged inverse ETF for very long.
The market often rallies during bear markets and all your gains could
evaporate in just a few days.
Second, I should also mention that inverse ETFs, whether
leveraged or not, use derivative instruments (futures, options, or other highly
leveraged and time-sensitive securities) with expiration dates. This means that the entire ETF, or at least a
large portion of its holdings expire and must be replaced every month or
two. This often results in exaggerated
volatility that does not necessarily match the actual market activity that the
ETF is designed to mimic, especially around the expiration/replacement
dates. And, of course the leveraged ETF
volatility can be even more exaggerated than the unlevered ones.
However, the good aspect of these securities is that they
can be very effective when used during a market crash or correction. It is hard to detect when the “real thing” is
happening until it gets up a head of steam but once we can see that a sustained
drop is in progress inverse ETFs can be very useful in protected at least a
portion of our hard earned gains.
Using Long/Short
Stock Positions
The history of long/short portfolios is absolutely
horrible. The reason is because too
often portfolio managers invest based more upon the story rather than the real
fundamentals. And even when the
fundamentals are used as the basis for selecting the candidates, technical
analysis is often overlooked meaning that a stock with terrible fundamentals
may have a rabid following that creates momentum which often overrides the
fundamental outlook for a stock.
There are, of course, other reasons why the strategy fails
more often than not but I will try to emphasize a more practical approach that
emphasizes superior analysis on both sides of the equation. The key is selecting stocks that have great
potential upside to buy and pairing those positions with stocks of companies
that are on the verge of collapse (or rapidly moving in that direction) to sell
short.
Too often investors try to match the best and worst stocks
in a single industry. But time and again
a rising tide can lift all boats so when an industry is doing well even the
worst stocks can perform better than expected.
Even if the long position outperforms the short side the limited
allocation to the longs creates a drag on overall portfolio performance. The better way to match pairs is to widen the
pairings to sectors as an entire sector can have both winners and losers more
readily.
I use the Friedrich algorithm to help me select my long
positions, of course, and I also use it as a screening tool to begin the
process of finding my shorts as well. A
good short candidate must have several qualities: it must lack momentum (and
not be a darling of Wall Street); it must carry an excessive amount of debt,
usually resulting from overpaying for an acquisition(s) that did not work out
as planned; it must generate negative free cash flow; it must have a weak cash
position (I like a quick ratio below 0.8).
Put all that together and you have a company that is heavily indebted,
short on cash, unable to generate enough cash to sustain operations with no
tangible assets available to use as collateral to raise additional funds. But I need all of those at the same time so
patience is key and using the right tools to sift through the thousands of
stocks are a must.
Using Bonds to Hedge
a Stock Portfolio
First, I don’t invest much of my portfolio in bonds when
interest rates are low and especially not when rates are rising. Remember that the price of bonds and their
respective yield have an inverse relationship.
When the yield rises the price falls and vice versa. So, when interest rates (yield) is rising the
price of a bond (principal) will fall.
The degree to which the price moves relative to yield depends upon the
time to maturity of the bond.
As an example, a U.S. Treasury bond with nine years to
maturity will fluctuate in price approximately 8% for each 1% rise or fall in
yield. So, if you hold a ten-year bond
today yielding about 2.93% (currently) and the yield rises to 3.9% one year
from now the value will fall by about 8% (it becomes a 9-year bond after a
year). The Fed intends to raise interest
rates by about 1% over the next 12 months so an 8% loss is almost certain if
you buy a 10-year bond today.
Of course, the idea behind buying bonds as a hedge is to
hold until maturity thereby incurring no risk to the principal. The problem is that you are also locked into
a lower yield than you could otherwise have achieved if you had waited another
year (or longer).
My preference is to not add new bonds positions until the
Fed appears ready to at least hold rates steady after a series of increases or
until it makes its first move to reduce rates.
It always seems better to me to hold bonds when interest rates are
falling because the price of my bonds rises to offset losses to stocks during a
recession. When does the Fed begin to
reduce rates? When the economy slows and
Fed officials are trying to provide support to an economy likely to fall into
recession (if it has not already done so).
So, in a recession we lose money on our stock positions but we make
money on our bonds positions to reduce the pain.
That is the reason that a good, conservative portfolio
manage will increase his/her allocation to bonds early in a recession and then
increase allocation to stocks when the economy begins to recover. This is also why those same savvy managers
increase the duration on bonds when rate increases stall and why they will
shorten the duration when rates get really low.
If your advisor does not actively manage your portfolio,
using at least a partial hedge strategy when stocks begin to fall your
portfolio may underperform.
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