Hedging Your Fund Against The Next Big Crash

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Includes: SPY

by: Serge d’Adesky

Summary

Protecting your portfolio against a sharp market drop is essential for today’s investor.

3 percent of your assets can hedge 100% of your portfolio.

Use options to ensure your portfolio will thrive in the next crash.

At the risk of being labeled a perma-bear, I will again repeat that it’s time for investors to revisit their hedging strategies. I won’t go into the reasons here. Instead, I’ll show you how you can cope with the risk of a 20% to 70% drop in the stock market without being crushed. This strategy can’t save you from all losses, but it can keep those losses small, without notably affecting your upside in case this prognosis is wrong.

Let’s assume you’ve got around $100k invested in a mix of growth and income companies paying you a great dividend – earnings you expect to be around 3% a year, with good prospects of moderate long-term growth and little chance of bankruptcy.

If you are in your 60s, 70s, or 80s, you might not be so sanguine about waiting out a 60-70 percent drop in the market.

So here’s how you can use options on a major index in order to sleep well at night.

First step: sell about $4,000 of your least performing investments in order to raise cash for this hedge. The hedge will cost you around $3,700 or 3.7% of your portfolio and will give you profits in a large drop in the markets as well as a continued market rise. It will limit your losses to a tolerable 6-8% in a moderate 10% to 20% drop in the markets.

Invest your money in what I label as a lopsided butterfly. Specifically, using today’s market values (April 15, 2018), you could spend $3,739 to establish the following positions:


Contract Position Average Cost Value
SPY DEC. 20 ’19 210 Put 8 $7.68 $6,148
SPY DEC. 20 ’19 100 Put 10 $0.39 $390
SPY DEC. 20 ’19 150 Put 15 $1.87 -$2,799

So how would this options play be affected by different market outcomes? Take the following 3 graphs with a pinch of salt. The first shows possible value ranges at 6 months, the second at 12 months, and the third most important graph at expiration of the options contracts on December 20, 2019, roughly 22 months out from today.

State after 6 months

State after 12 months

State at expiration after 22 months

Why the pinch of salt? Because we’ve not varied the volatility from its present value. This would introduce too many variables and just confuse the reader. True, on stark market drops, the volatility is likely to increase. Since this particular option setup is vega positive, it benefits from a rise in volatility. So actual profits would likely be higher than shown in the graphs and in the subsequent summary table. On a rising market, volatility is likely to decrease and the losses would be the same as shown in the tables below.

Our intention is to hold the options hedge to term, so the intermittent graphs are only important to give the investor an idea of how the options portfolio’s value is likely to fluctuate over time. If you know what could happen, you’re unlikely to bail out of the hedge too early.


Market Performance S&P 500 -40% -30% -20% -10% 0% +10% +20%
After 6 months +16% +12% +5% +0% -3.7% -3.7% -3.7%
After 12 months +17% +12% +5% 0%

-3.7%

-3.7% -3.7%
After 22 months +40% +35% +10% -3.7% -3.7% -3.7% -3.7%

Now let’s map the effect of various market scenarios on your growth and income portfolio. We are assuming that these holdings drop a little less than the overall S&P 500, but also rise a little less. Also, remember the assumption that you now have 97% of money in dividend paying stocks paying 3% dividends


Core Portfolio Value -35% -30% -18% -5% 0% +10% +15%

Dividend Income

(22 months return)

+5.5% +5.5% +5.5% +5.5% +5.5% +5.5% +5.5%

Total Return Entire Portfolio

Adding in Options Return

+10.5% +10.5% -3.5% -3.2% -3.2% +11.8% 16.8%

As you see, this hedge provides great protection against a big drop in the market, allowing you to reap around 10% profits even in the case of a market meltdown. Yet, it still does well in a market rise. Unfortunately, the trade-off is in the case of a small market swoon in the 0% to -20%. Here you lose around 3% overall, including your dividend income.

For most investors though, that is something they can live with.

Disclosure: All investments involve risk. In particular, options hedges are complicated products and should only be undertaken by knowledgeable investors. This is not a solicitation to buy or sell.

Disclosure: I am/we are long SPY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

A Paradigm Shift – Oil Displaced

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They say a picture speak a thousand words. In that case this video speaks volumes. Take a 15 minute dive into the next paradigm shift: the end of oil’s dominance in global economics. Enjoy the video, courtesy of Bloomberg. Oh, and if you happen to be an oil sheik – this would be a good time to start trembling.

Yasukawa Finally Corrects – Now We Like It

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As readers of my blog know, I’m a big believer in the growth of Robotics, the rationale for which you can view here. One of the best companies in this sector is Yasukawa, but the last time I discussed it, I suggested waiting for a better price as the company had been overbought.

Since then, the stock has dropped to $87.50, a 21% drop, where it seems to have found support. I previously suggested buying in at prices of $91 and lower. That time is now. What caused the drop? Here’s the take from the Nikei Asian Review:

Yasukawa, one of last year’s strongest-growing components on the Nikkei Stock Average, beat most peers to releasing earnings for the nine months through December, publishing its report after markets closed Tuesday. The showing was strong, with consolidated net profit roughly doubling year on year as the company seized on demand for factory automation in labor-short markets like China.

But in maintaining a forecast of 39 billion yen ($357 million) in net profit for the full year through March, the robotics company fell short of market predictions of 40.4 billion yen. It fell victim to “the market’s overly high expectations,” in the words of Yasuhiko Hirakawa at Sumitomo Mitsui Asset Management.

Remember the adage of buying when others are fearful? Now’s the time. Here’s what my technical crystal ball shows:



Click to enlarge

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Disclosure: The material presented on this site is for illustrative and educational purposes only. and is not personal investment advice to any specific person for any particular purpose. Be sure to read our disclosure page located in the right hand menu item.

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Micron – Riding the Artifical Intelligence Wave

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How do you benefit from the likely growth of AI (Artificial Intelligence), Gaming, assisted reality applications, and driverless car technologies? Buy the companies that produce the technologies at the heart of these applications.

As one web commentator put it succinctly, this market is dominated by a few players. “Intel and Micron are the only companies that have the know how to manufacture 3D Xpoint… DRAM market is controlled by Samsung, Micron and SK Hynix.. … this sector is totally controlled by just few players and no one else is even close.”

This post makes the case for Micron.
1) NAND will be the backbone storage system for the avalanche of new data produced by the Internet of Things. Other technologies will play important roles, but NAND will be dominant over at least a decade.
Projected NAND growth
2) NAND supply will seriously lag demand, forcing prices higher, and richly rewarding leading NAND producers.

3) Micron is will poised to dominate this sector, along with Samsung and 5K Hynix.

I want to give credit to one of my Seeking Alpha colleagues “Truth Investor” for his great analysis of this stock : DRAM strength and Micron Be sure to read more on this company there.

Disclosure: All investments involve risk. This is not a solicitation to buy or sell. Please read our full disclosure on this site.

Protected: Your Growth Portfolio

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Everything You Need to Know About Investing in 30 Minutes

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In this simple, entertaining, yet utterly brilliant 30 minute presentation, Ray Dalio – co CEO of one of America’s leading hedge funds – explains how the economy works. Don’t be misled by its comic-like graphics. This video provides an understanding of the underpinnings of modern economies that escapes the understanding of the average investor.
You do want to be a better than average investor, right? Take a listen:

The Death of The Balanced Portfolio

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For the last 200 years, it has always been safe to invest in a balanced portfolio of stocks and bonds, weighting more heavily towards equities at a young age, and more heavily towards bonds as the years pass. Over time, you could count on your wealth increasing and outpacing the cost of living, and leaving you in good shape to face your last decade or so of retirement.

That was then. This is now. We are facing a time when that traditional approach will fail miserably. When equities go through their inevitable correction – its a question of when they do that, not whether they will do it – investors will find no safety in bonds. Long term treasuries will drop by 30% to 60% , short-term bonds will drop a lot less, but still enough to cancel out two or three years of dividends.

Readers of this blog will not be shocked by this admittedly depressing and alarming assertion. A previous posting dealt with a number of warning signs I see forming on the horizon and explored this topic.

But my reasonings were not born in a vacuum. There is a saying that “true genius is built on the shoulders of giants”. More appropriate in my case would be Robert Burton’s saying that ” A dwarf standing on the shoulders of a giant may see farther than a giant himself.”

In that vein, let me point you to the musings and concerns of the very well-respected economist and newsletter writer John Mauldin, who brilliantly diagnoses the dismal economic corner the world has painted itself into, which can only end in tears.

Negative Rates Nail Savers

Be sure to read the follow on article:
Start Moving Some Dirt

A followup posting to this will suggest some concrete defensive steps you can take to protect and grow your portfolio in these challenging times.

Traditional Investments Approaches May Be Broken

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Traditionally, one of the safest investments strategies for folks close to or in retirement was a 60% / 40% stock bond ratio, invested in the well-run, low cost or no-load mutual funds. This article explains why “This Time It Really Is Different”, and investors pursuing that approach today may suffer profound regret.

But first check out this graph, showing how well a balanced approach has done:

(click to enlarge)

As this shows, over the last decade investors in Vanguard’s VWELX or VWINX fund would have gained more than investing in the S&P 500 (up 96% over the period), 150% and 131% respectively. Equally important, they would have done so with far less drawdowns in the crash of 2008 (24% and 48% vs S&P’S 78% drop).

In fact, as I’ve shown in a previous article in , Seeking AlpSeeking Alpha’s financial blogh, this outperformance of the 40/60 balanced approach holds well going back over another decade.

But today, I am convinced, the logic behind those patterns no longer holds.
As a consequence, both stocks and bonds will drop in sequence, rather than acting as counterbalances. This means that your 60% stock holdings could bring you a huge amount of pain, while your bonds only bring you a large amount of pain. Either way, the next effect is very painful.

I liken the moment we find ourselves that of the real estate market in mid 2006. The signs of a crash were imminent, and many smart people were warning of ludicrous values, dangerous mortgages, shady mortgage practices, and a warped property to income ratios. I remember at that time warning a friend of mine not to engage in his fourth house flipping in 10 years. Unfortunately for him, he ignored my advice, only to be later faced with a $1 million mortgage on a $500,000 equity value and monthly payments double his income.

Back in 2006, I could not tell him for sure when a crash would happen, and what event would trigger it. I just recognized that values were not sustainable. In fact my timing was a bit off. Another year passed before housing prices lost 70% of their value. As you can see in the graph of Real Estate Investment Trust prices below, real estate values climbed another 20% over the next year.

Was I wrong to warn him off his investment? Obviously not. Many small fortunes were built on the precept of “selling a bit too soon”, and far more were lost on the premise of “following the wisdom of the crowd”.

So now let’s look a today’s situation. Six factors show that these stock market valuations are not sustainable, and that a significant correction must follow soon:

  1. Shiller’s Historical Price Ratio . P/E ratios, fueled by the FED’s money printing, are at levels usually found just before market crashes.

    (click to enlarge)
    source: gurufocus.com

    The last time Shiller PE ratios were above 27 was in 1929, 2000 and 2008. The S&P 500 subsequently crashed by 90%, 33% and 47% over the next 18 months. (Readers are encouraged to visit the gurufocus site for an explanation of Shiller’s research and findings.)

  2. Corporations are propping up stocks by using “quasi-free” money by borrowing in corporate markets.

    (click to enlarge)
    source: bloomberg.com

    In the past, when borrowing levels got so high, market crashes often followed. Will this time be different?

  3. One of the biggest areas of concern, is that corporations are not making the capital investments that result in real long term growth.

    (click to enlarge)
    source: bloomberg.com

    Even the economists at the FED – not exactly innocent of a role in the decline of capital goods spending – recognize the danger in this steep decline. They attribute 80 percent of a country’s future growth to the investment in capital goods, as a recent FED study demonstrates.

  4. Corporate profits have declined over the last four quarters, yet the stock market is making higher highs. Bubble anyone?
  5. Productivity has ground to a halt.
  6. The money supply (M2) has been increasing by 6-7% a year, which has always ended in the past in inflation.

OK, so maybe you believe that a stock market correction is possible, and even probable. But why does that imply that both stocks and bonds will decline, and that the traditional haven of bonds will not hold?

The answer is: because overall bonds are overvalued. Today, if you invest in any company that can be reasonably assured of avoiding bankruptcy even in a severe market downturn, you are paid around a miserly 2% over 10 years. If long term interest rates regain even half the value by which they have dropped in the last 6 years, an investor buying those bonds would see values decline by far more than their coupon payments. If instead of selling at a loss, they hold them to term to obtain a return of capital, on a net basis they are likely to be a loser to inflation.

If, on the other hand, you go for higher interest rates to protect from possible future inflation and interest rate hikes, you are now faced with greatly increased risks of default and total loss of principal.

But wait, you say, there is no inflation anywhere on the horizon! Watch out, says Federal Reserve Alan Greenspan. If he is right, we may get both a drop in the markets AND higher inflation, and consequently higher interest rates. In a recent interview with Bloomberg News, Greenspan commented: “I know if you look at human history, there are times and times again where we thought that there was no inflation and everything was just going fine. And I just basically say, wait. This is not the way this thing ordinarily comes up. I don’t know. I cannot say I see it on the horizon. In fact, commodity prices are soggy. The oil prices has had a terrific impact on global inflation. It’s not about to emerge quickly, but I would not be surprised to see the next unexpected move to be on the inflation side. You don’t have inflation now. And you don’t have it until it happens.”

There is one scenario that is good for bonds, and in this author’s opinion is more likely to happen. That is a severe and prolonged recession affecting most of the global economy. In that case the central banks of the world may decide to keep interest rates low and possibly even go negative, as Europe and Japan have already done.

A strong corporate or government bond bought today with a duration of 10 years would see appreciation of 10% , 20% and even 30% in the event of a decline from 2% levels to levels of negative 1% and negative 2%. Unfortunately, such an outcome is not only a likely result of a severe drop in stock markets and real returns worldwide, but also may even exacerbate those conditions – due to its negative psychological impact on investor confidence and disruptive impact on careful capital allocation.

So the small gain you might see in the 40% of your portfolio held in bonds could be more than swamped by the disruption in your stock portfolio.

It is these dismal future prospects that have led people Warren Buffett to project that future decades will not bring the 9% averages a long term investor could aspire to, but rather much lower averages in the 2-4% range.

This view is shared by Bill Gross, one of the most successful bond managers of the last 20 years and current manager of the $1.5 billion Janus Global Unconstrained Bond Fund: “I don’t like bonds; I don’t like most stocks; I don’t like private equity,” Gross, wrote in his recent monthly investment outlook Wednesday.”

An overall mixed portfolio that could yield 8% to 10% on average in the past is more likely to product 2% to 4% in the future, with a lot of short term pain along the way.

Just so that we don’t end up on a completely pessimistic note, there are strategies than can outperform even in these confusing and distressed times. Conservative investors may want to look at this post while investors able to tolerate more volatility would want to look at a mean-reversion algorithmic approach, as described in a previous post. Here’s how that has performed in historic backtesting:

Same Bumps, But A Lot More Ride

  • Long Short Mean Reversion
  • Performance-based limited selection
  • Less conservative hedging allocation
  • Mean reversion methodology
  • Goes short and long simultaneously
  • Not compatible for IRA’s

(click to enlarge)


Jan 4, 2003 – July 17, 2015

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Disclosure: The material presented on this site is for illustrative and educational purposes only. The graphs shown above represent back tested results and do not reflect actual investing results. Investing in options involves risk of loss, and these losses can be substantial. Only risk capital should be used when trading options. We do not currently own any funds discussed in this article. We are a fee-only investment advisor, and are compensated only by our clients. We do not sell securities, and do not receive any form of revenue or incentive from any source other than directly from clients. We are not affiliated with any securities dealer, any fund, any fund sponsor or any company issuer of any security. This report is for informational purposes only, and is not personal investment advice to any specific person for any particular purpose. We utilize information sources that we believe to be reliable, but do not warrant the accuracy of those sources or our analysis. Past performance is no guarantee of future performance. Do not rely solely on this research report when making an investment decision. Other factors may be important too. Consider seeking professional advice before implementing your portfolio ideas.

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What Do Negative Interest Rates Really Mean?

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More and more of my clients are puzzled about the impact of negative interest rates. Some economists believe there is nothing special about negative interest rates, and that their impact will be just “business as usual”.

I disagree. Interest rates are the price of money. When it is negative, money turns free. When money is free, a lot of bad business decisions are made. Profits are sought in levered, and super-levered constructions of obtuse financial instruments, and real capital formation is postponed.

Remember the tower of Babel?

Confessions of An Unrepentant Bear

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For those of you who have not yet discovered the blog, I recommend HedgeEye, a great place to find those market moving early data insights that can make a big difference to your medium term and long term investment strategies.

As we approach the period of summer doldrums in 2016, I cannot help but scratch my head in wonder as the market makes new highs in spite of all the looming signs of a world economy on the precipice of a severe and prolonged decline. This kind of reminds me of the tech boom of the 2000′s, as ridiculous business propositions earned sky-high valuations based on pumped up “eyeball” counts.

Rather than recounting again the myriad signs of trouble on the horizon, I’d like to simply tell my readers : be very cautious. In this video, Mike O’Rourke, Chief Market Strategist at Jones Trading gives a good explanation of what ill winds blow:

Market Warning Signs At All Time HIgh

So what’s a safe strategy in times like these? Check out my recent article on Steepener Bonds written for Seeking Alpha, combined with a long term bearish option hedge.

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