STRATEGY UPDATE – HEDGE, HEDGE & HEDGE
The market has made an enormous move in a very short period of time. The 8% move over the past 6 trading sessions is beyond normal. Unlike the March bottom where we were coming off of extremely oversold levels, the current rally is coming off of only slightly oversold levels. Unlike the March bottom where we said the initial 10% was likely to lead to more follow-through, I am not as optimistic here. The recent move has sent the market into an overbought scenario in a very short period of time. It’s likely that the smart money will begin waiting for a better opportunity to get in. That means we could see the buying begin to taper off in the coming days. I still believe there is no real catalyst to send the market substantially lower, however, so don’t expect the market to fall off a cliff here.
Quick moves like we’ve seen in the last few days never make me feel comfortable. The “better than expected” earnings trade has gotten extremely crowded. As regular readers know, when one side of the boat starts to get too crowded I always like to jump off or move to the other side. At this time, I think it’s prudent to move to a more mildly bullish position, but I certainly don’t feel comfortable getting short at these levels. The risk of near-term downside is very high, however, I would expect any downside to be short-lived and relatively minor. I would expect buyers to come in 3-5% lower from here.
With that said, it’s prudent to throw on some hedges here if you haven’t already. The current JP Morgan strategy outlook provides a relatively good framework:
One of the best ways to hedge potential downside is to write calls on the positions you might own, however, since we’re not all options traders I’ll detail a few other potential ideas. If you’re a small investor without an options account you might consider a fund like PBP which is an option writing S&P 500 fund.
Although JP Morgan likes shorting oil here I have to disagree. I prefer to hedge with non-correlated assets and oil’s correlation to the equity markets is very close to 1:1 in the last few months. I would be more inclined to hedge with fixed income and currency instruments. The simplest hedges are the risk aversion trades. Although the Yen has been my “go to” risk aversion trade over the last few months I currently believe the Yen is unattractive when compared to its alternative risk aversion play: the US Dollar. I would also favor long dated bonds as a risk aversion play. It’s important to note that I like these instruments purely as hedging instruments. On their own I have little conviction. The beauty of using these kinds of instruments is that I am not picking assets, but rather picking correlation. Hedging with non-correlated assets is a lot like being able to pick heads AND tails in a coin flip.
Warren Buffett’s first rule of investing is “don’t ever lose money”. His second rule is “don’t ever forget rule #1.” Hedging is the art of protecting your downside risk. Of course, those who misinterpret Mr. Buffett’s strategy don’t see the brilliance behind what is essentially a massive covered call approach. Buffett writes billions of dollars of life insurance premiums from Berkshire’s insurance units and then uses the cash flow to purchase equities. Many view his strategy as a pure value approach. I call that the greatest lie ever told to the investing public. The takeaway from this is that Buffett is a genius in not losing money. The primary reason? He is a genius at protecting his gains. I think now is the time for you to do the same.
Being hedged 100% is a zero sum game, since if the market is efficient the hedge extracts the returns of the investment being hedged. Intermittent hedging is market timing, which conventional wisdom holds to be ineffective.
I think it goes without saying that you don’t hedge dollar for dollar….And it’s actually a negative sum game if you do. You’re just paying fees to your broker while you watch the prices go no where. That’s clearly not what I am implying people should be doing….
TPC,
Appreciate the inclusion of and suggestions for the smaller investor. Very helpful.
Thanks.
TPC: As I noted this weekend we are going to have a strong up-move in the market this week–Why is the question–we can say the market has discounted all the bad news and “Less Bad” has been rationalized to GOOD !–we can look a CNBC,Fox Bloomberg TV –”Green Shouts” everywhere–this Perception is the Trade. Larry,”Curly” Geitner and “Mo” Volker backed up by “Bubbles” Bernanke—what in the world are you so worried about?? —and last but not least as you said– lot of big-money on the sidelines they don’t want to be left at the station!! This is not a “roaring” Bull move this is a “snorting” Bull move–as I mentioned this market remindes me of 1987 from a Perception standpoint–what you are seeing is a blow-off rally in a secular “Bear Market”–Green Shouts,Green Houses,Green Cars,pretty soon we will all be pooping green!
Interesting Price-Volume relationship:
http://dshort.com/charts/bears/price-and-volume-large.gif
Warren Buffett’s first rule of investing is “don’t ever lose money”. His second rule is “don’t ever forget rule #1.”
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i wish you followed his own “rules”, it is easy to make up rules and much harder to follow them which is proved by his investments in recent years
Warren Buffett’s first rule of investing is “don’t ever lose money”. His second rule is “don’t ever forget rule #1.”
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i wish he followed his own “rules”, it is easy to make up rules and much harder to follow them which is proved by his investments in recent years
sorry for the double post, i made a typo and was not able to cancel it on time. I ment “he” must follow his own rules. Kinda hard when you are invested heavily in insurance and banks and those crashed. Also, he was saved by the GS free gov money too, otherwise his stake was down 50% at some point and who knows if it was not gonig to 0.
Anyway, did not you said just yesterday or day before that you are slightly bullish? Did you changed your position? Sorry to ask, it is notevery day that i read your blog so sometimes the change in posture can be visible.
I’m hedging with specific sector etf bear put spreads – XRT, SRS, EEV
So where is the next leg up going to come from? Technology is topping out. Oil is over-extended.
My theory is that we’ll need new sector leadership to keep this rally intact. If we don’t see strength in a new sector such as basic materials or health care, the market is toast. Hence, I’m also long UYG & XLV. I can see potential mega-cap multiple expansion as a market catalyst as well and am using DDM to capture that potential outperformance.
Bzik,
I am still bullish, but throwing on some hedges here to protect from any downside. We’ve had a great run since last week so I am not getting greedy. You can call me bullish, but less so….
As for Buffett, he is still generate incredible cash flows from Berkshire. The losses in his portfolio matter little to him over the near-term.
Yeah TPC, I thought you said you were going neutral at 870?? Did you say jump on the bull train, I must have missed that.
market changes mood every day what poor TCP to do? just follow the market
By the way, TheChartist recommended 100% cash couple of weeks ago just to recommend 100% invested today. I guess lots of people were watching head/shoulders too carefully and got fooled by it
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