Defying Gravity: The Case For Hedging Against A Market Downturn

Tyler Durden's picture

Submitted by Adam Taggart via Peak Prosperity,

And nobody in all of Oz
No Wizard that there is or was
Is ever gonna bring me down!

~ Wicked, "Defying Gravity"

Today's markets exist in an Oz-like, fantasy world. For 5 years now, stock and bond prices have risen like Dorothy's balloon, with hardly a puff of downdraft to spoil the fun.

Everybody likes higher prices, so let's have them always go up! Forever!

Whether that can indeed happen is a topic of hot debate, though few are yet willing to predict corrections have been permanently banished from the financial markets.

In this article, we investigate the rationale for prudent hedging in light of today's elevated prices. If, like most investors, your portfolio is positioned long-only (i.e., betting on a continuation of higher prices) and is mostly-to-fully invested in stocks and bonds, read on to learn why having insurance against a market correction is a wise move to consider at this time.

Too Much Of A Good Thing

Consider the price performance of the S&P 500 since it bottomed after the 2008 crisis. It has now enjoyed 34 straight months of upward movement without a correction of 10% (there have only been 2 longer correction-free stretches for the index in the past 25 years):

Furthermore, this half decade-long rally has been unusually strong. Since the end of 2012, the S&P has tested its 100-day DMA only 15 times (that's really infrequent), and traded below is 200-day DMA zero times (that's shocking). 

It's no wonder that investors, lulled (or bored, one might say) by the monotonous and volatility-free pleasant performance, have come to believe we're at a new permanently high plateau for asset prices. And so they expect more of the same in the future.

Many believe these higher prices are due to the US' status as the "cleanest shirt in the laundry hamper". That as long as economic conditions are relatively worse in Europe (which they indeed are) and in Asia (and China is definitely looking sicker by the week), and the world's central banks continue their easing policies (which they very likely will), then the huge pool of global capital will continue to slosh into US assets looking for better returns and/or safer haven.

And the parade of mainstream articles like the following (note the S&P 3,000 tease) certainly helps investor confidence in the party's continuation:

Stocks: Bull market alive for 2,000 days (CNN Money)

 

Too late to jump in? All of this has led some on Wall Street to fear the string of good luck could be nearing an end. Some even believe stocks are in the midst of a bubble that could pop in an ugly way soon.

 

But optimism is still the driving force in investment circles. More optimistic forecasters say it's not too late to jump into the market, even if you've missed the gigantic rally over the past five years.

 

"We don't see any prospect of a recession any time soon," said Bruce McCain, who helps oversee more than $20 billion as chief investment strategist at Key Private Bank.

 

While the size of the upcoming gains might be more muted, McCain said "you should be able to capitalize on overall earnings growth."

 

Amoroso echoed that sentiment, saying: "It's not too late but investors do need to realize that expectations of future returns have come down."

 

A few market watchers remain very bullish on stocks. Last week Morgan Stanley predicted the S&P 500 could surge to 3,000 by 2020 because the lackluster economic recovery doesn't appear nearing its end.

 

(source)

In fact, the ratio of bullish to bearish analysts is at all-time highs right now (underscored by Monday's news that David Bianco just upped his year-end S&P target by 200 points):

(source)

So, here we are. A 34-month long winning streak, with practically every analyst on the same side of the boat, confident that "things will go higher from here".

It's just like a fairy tale.

Warning Signs

We spill a lot of (digital) ink here at Peak Prosperity identifying the data and fundamentals-driven evidence that suggest not only is the current market rally unsustainable, but that much of it is based on accounting chicanery, faulty assumptions, intervention, manipulation and fraud. Here are recent examples from Chris, Charles Hugh Smith, Brian Pretti and myself (while writing this article, Charles directed me to an excellent recap of current market risks by John Hampson which can be read here).

But ignoring all of that for the moment, even if you choose to subscribe to the bullish case, there are still very compelling reasons you should consider holding some insurance here.

Historical Comparison

First off, occasional corrections are good for bull markets. They keep the uptrend from getting out ahead of itself too much, otherwise larger, more painful downdrafts will result when corrections do occur. Now ask yourself: Is a 5-year bull run ,with zero 10% corrections over the past 3 years, likely to be more or less painful when it does drop?

Answer: More. Likely a LOT more.

Technical Analysis

From the technical analysis side, there are lots of indicators that the current rally is 'long in the tooth'. From The Keystone Speculator:

The bears have the weekly chart on a silver platter. The prior top in July was an easy call based on neggie d and now the chart is set up again favorably for bears.

 

The blue and red rising wedges, overbot stochastics and universal negative divergence across all indicators want to see a spank down and lower prices ahead. Price is extended well above the moving averages requiring a mean reversion lower. The candlestick from last week is a doji indicating that a trend change is on tap

 

(source)

The technicals are clearly flashing warning lights that stocks are in "overbought" territory.

Watching The Smart Money

It's always wise to watch what the successful players are doing. And in the current environment, they're taking a lot of their chips off the table. From Zero Hedge:

Icahn, Soros, Druckenmiller, And Now Zell: The Billionaires Are All Quietly Preparing For The Plunge

 

"The stock market is at an all-time, but economic activity is not at an all-time," explains billionaire investor Sam Zell to CNBC this morning, adding that, "every company that's missed has missed on the revenue side, which is a reflection that there's a demand issue; and when you got a demand issue it's hard to imagine the stock market at an all-time high." Zell said he is being very cautious adding to stocks and cutting some positions because "I don't remember any time in my career where there have been as many wildcards floating out there that have the potential to be very significant and alter people's thinking." Zell also discussed his view on Obama's Fed encouraging disparity and on tax inversions, but concludes, rather ominously, "this is the first time I ever remember where having cash isn't such a terrible thing." Zell's calls should not be shocking following George Soros. Stan Druckenmiller, and Carl Icahn's warnings that there is trouble ahead.

 

(read full article here)

These investors each amassed billions through decades of investing savvy. If your portfolio is still fully allocated to stocks and bonds, it's worth investigating: What do these guys see that I don't?

The Prudence of Hedging

Risk management is the bedrock of investing successfully over time. 

You always want to have protection in place and/or diversified holdings in case your main strategy doesn't pan out as intended. Remember, a 25% drop in your portfolio means it then has to gain 33% just to break even (and it's pretty easy to find credible predictions for a coming correction of 50% or more). 

You also want to have some liquidity held in reserve to take advantage of 'no brainer' opportunities when they come your way. Remember the old maxim: Buy low, sell high. Just about everything is priced at "high" today by traditional valuation metrics. Keep some cash on hand to deploy in the aftermath of a correction, when prices are more favorable.

Most investors only come to appreciate the wisdom of these lessons painfully, after a market downdraft has burned them. Wiser investors hedge.

"Hedging" is the practice of allocating a minority percentage of your investments to safer or inversely-correlated holdings relative to the majority of what's in your portfolio. Simply increasing the percentage of your portfolio held in cash -- particularly during times of apparent overvaluation, like now -- is an easy and practically risk-free hedging step that anyone can do.

In Part 2: How to Hedge Against A Market Correction, we explore the standard range of hedging techniques that are commonly used to offer portfolio protection and/or upside during a market downturn. These include stops, inverse and leveraged securities, shorting, options, and futures.

And for those who choose to forgo hedging, you might want to pick up a pair of ruby slippers. If you get caught by a market correction, click them together three times and pray like heck they return your nest egg to the value it was before...

Click here to access Part 2 of this report (free executive summary; enrollment required for full access)

 

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NoDebt's picture

Not always.  If you're early, it's the same as being wrong.  Those techniques all put a drag on returns.  Start falling behind in a straight-up market and clients get grumpy.  Assets find a new home.

Remember that a lot of managers are paid on AUM (assets under management).  It is their god.  So they take more risk in many cases than they should.  Even individual companies are doing a version of that by borrowing money to fund dividend increases and share repurchases.

Now if you manage your own portfolio (which most people absolutely suck at), you are, of course, free to do as you choose.

My favorite hedges are simple- physical and cash.  

Gromit's picture

I've hedged.....with SPY puts September and October.

Pinto Currency's picture

 

 

Technicals are irrelevant when you're printing trillions and using still hot money to buy equities.

Just print more and buy more all the time.

Every dip, buy more until everything explodes.

Karlus's picture

Agreed, timing is everything.

 

I wonder if the BS line about it not being possible to time the market is propaganda put out by hedgies to stay in all the time because they have to and get their 2 and 20.

 

I dont think its impossible to time the market at all. I remember back when investment banks could trade their own books and the P&L didnt just earn itself.

 

Hedge funds used to mean that they had inverse coorelation with the market, but now it just means prop trading thats not in a bank.

 

I think there are prob some obvious things out there and you can ride the crash down and then back up.

Problem is getting your profits out or useful if they do the Cyprus on us

intric8's picture

The most artworthy, textbook, undeniable negative divergences could set up with multiple indicators only to see the pattern continue and get stretched out over a much longer time frame, or get destroyed altogether by more market manipulation. and the shorts along with it

adr's picture

The nothing matters but the .1% making out like bandits with money they printed themselves rally.

Can we call the Secret Service on the Fed, I mean they are pretty much counterfeiting and using the fake cash to buy things. In fact they are also guilty of money laundering since they are using the cash to buy items and then selling them to others for real earned money.

If you or I do what the Fed does, we go to jail. The heads of the banks that own the Fed do it and they get new yachts, Manhattan condos, and exotic cars.

 

max2205's picture

The Fed will tell those fat cats when to sell and only then will they or else they get the high dive nail gun hot tub treatment.

q99x2's picture

During WWII machine shops did very well. This time I think radiation suits and bio-hazard suits as well as weapons suppliers will do well.

Eyeroller's picture

Anyone see the AP article about a particularly bad solar storm set to hit the Earth on Sept. 11th?

 

Bangalore Equity Trader's picture

Listen. Does anyone "KNOW" how I can enroll as a paying member on this guys site? I can't enroll from here in India. I can't even get to his site!

himaroid's picture

"We represent the Lollipop Guild, Lollipop Guild, Lollipop Guild,

  We represent the Lollipop Guild,

  And we wish to welcome you to to SUCKERS Land!"

sidiji's picture

author has no idea of the difference between nominal and real valuations...duh doofus, what do you think happens when the central bank inflates the money supply?...you need to adjust your idiot chart to reflct constant dollar...but i doubt you know how to do that....go back to school and learn some basic econ before making more of an ass of yourself

EBT excepted's picture

...up-arrow for the sheer brutality...

Karlus's picture

FINISH HIM.....FATALITY!!!

StandardDeviant's picture

Also... "Straight-Line 200% Increase"?  Sure, it's a hell of a bull run, but we had about a 15% drop in 3Q2011 alone.  Hardly a straight line.

potato's picture

Here is the thing. If you're hedging downside, you're fighting against 120 million in the USA alone. Plus I don't know how many people pay taxes in Europe (probably at least 4 million). 

The best thing to do is secure basics and leverage every speculative cent into the market.

walküre's picture

love, love the picture!

yogibear's picture

Lots of buy-and-hold people bragging now.

Saying traders are losers.

401K of Dooom's picture

"The technicals are clearly flashing warning lights that stocks are in "overbought" territory".  Oh you think?  I think we jumped the shark when the economy went from producing items like the IBM  360 mainframe, 65 Mustang, Swanson TV dinners, personal computers ( I include the IBM's, pc clones such as Dell, Gateway, HP and the Macintosh), textiles, muscle cars, aircraft of all types ( including the most heartbreaking cancellation, the XB-70 Valkyrie!) and those standardized school lunch boxes we used to carry to school.  Now all we have are facebook accounts, social media and mochelle's school lunches.  Just wait until the phricking Medellin cartel begins to smuggle in junk food to our schools - they'll make more money on that than Cocaine! Snort, snort!

This is unfortunately the gentrification of America!  The Damm Hippies and New England Trancendentalists of New England planned this long ago in order to screw everyone!  Now we can enjoy as we power our homes with exercise bikes and they use Mexicans to power their homes on exervcise bikes and treadmills!  Think I'm crazy?  Then why are they calling all the shots and we get stuck with the bill and loose our rights?  Oh and if they have a right to get stoned with pot, then I have an inalienable right to creat more carbon in the atmosphere to enjoy my standard of living.  And in turn cause "Global Climate Change".  Just think, when the polar ice caps melt, all the people on the coasts and low lands will be drowned.  Hey you wanted to reduce the human carbon foot print, why do you take exception to my methods?  Oh sorry, male PMS and it's the anniversary of 911!

oudinot's picture

THE END OF THE BULL MARKET IS UPON US

svkhost's picture

Those shoes are silver in the original book version.

d edwards's picture

Yellen is the Wicked Witch.