6 Candidates for
Hedging Your Portfolio
- Beware the near-universal consensus that Fed stimulus will keep pushing stocks relentlessly higher.
- Inside: Assets that can gain when the stock market tanks.
The U.S. stock market continues to defy the gravity of a sluggish economy, as the major indices trade near all-time highs in the early goings of 2014. The rally since the 2009 bottom has been truly enormous, but it has yet to be confirmed by much corresponding improvement in the economy.
Despite the government telling us that unemployment is falling, the reality is that in January, the actual workforce participation rate fell to its lowest level since 1978! The official unemployment statistic is a joke. The only reason that it’s falling is because millions of people have dropped out of the workforce entirely since the recession “ended” in June 2009, and therefore aren’t counted at all.
So what the heck is driving stocks if the real economy still stinks? Every major bull market has a story that everyone in the media employs to try to explain and justify the bull market – all the way up to the very top. The “top” of a market is just when the most people latch onto the story and believe it with the greatest conviction – whether it’s the “roaring 20s” or the new-era technology story of the late 1990s.
Of course, we can only know in retrospect when the exact top of a bull market will occur, but we can observe in real time whether sentiment conditions that are consistent with a major top are in place. They appear to be in place today.
Now Even Fed Critics Have Total Faith
in the Fed’s Backstopping of Stocks
What’s the story that nearly everyone believes in today and uses to justify high stock valuations and forecasts for ever-higher stock prices? It’s not technology or a roaring economy – this time, it’s the Federal Reserve.
The Fed came to the rescue in 2008, saving the banking system, and engineering a stock market rally. Now, a lot of people think that stocks will go up forever because of the Fed. What’s surprising (and telling) is that even the harshest critics of the Fed’s actions – some of the same people who had previously expressed skepticism that Ben Bernanke and company could stop the Dow from crashing – are now convinced that stocks will go higher and higher as long as the Fed keeps stimulating.
Many prominent commentators in the hard money camp, including Peter Schiff, are buying into and repeating this narrative now, after having been bearish during earlier stages of the bull market. Did they not notice that precious metals prices have fallen sharply after running up for several years into their 2011 highs? Fed stimulus didn’t keep gold and silver from slipping into a cyclical bear market. (In my view, the fundamental case for a secular bull market is still intact; I discuss the prospects for gold as a safe haven later in this story.)
Now that stocks have had a huge multi-year run-up and become overextended by several long-term valuation, sentiment, and technical indicators, the S&P 500 looks to me like it’s nearing a major top – perhaps a generational top. The stock market’s persistent refusal to reflect underlying economic realities has left bears frustrated and defeated, with some even switching to the other side.
Our longstanding forecast since 2005 has been for stocks to trade much as they did from 1966-1982 – volatile, with severe bull and bear moves within an overall sideways market that could see the Dow and S&P 500 in 2020 end up right where they started. The bull leg that we’re currently in has gone farther than we expected, but it’s not yet defying the 1966-1982 model, which saw nominal new all-time highs in 1973 that weren’t real in inflation-adjusted terms and gave way to a down leg that took prices back into the trading range.
“Like the Boom before the Dot Com Bubble Burst…”
Now is a dangerous time to be investing in U.S. stocks – at least with regard to the most popular sectors fueled by margin debt, which is now at an all-time high (typically the case at market tops of significance). Sentiment surveys (Investors Intelligence, etc.) show bullishness among the public and advisors near record highs and bearishness near all-time lows.
Markets move on changes in participation levels. When everyone has already piled onto one side of the trade, who’s going to keep the market moving higher? New people could potentially come in from the sidelines, but when small numbers of the masses of people who are in the market decide they want out, the market could move in a big way – to the downside.
Market analyst Bert Dohmen of Dohmen Capital remarked in a recent Forbes column (January 6, 2014), “Some of the top performing stocks in late 2013 were selling at astronomical valuations. Some have no earnings. This is like the boom going into March 2000 before the dot com bubble burst… everything indicates excessive bullish sentiment normally only seen near important market tops.”
In case he’s right, let’s now consider some ways in which you might re-allocate some of your investment capital to protect yourself from a market decline.
Candidate #1: Short Selling
and Derivate Bets on Downside Action
Seemingly, the most direct way to hedge a portfolio against a stock market decline would be to own instruments designed to rise as the stock indices fall. For example, you could sell short the SPDR S&P 500 (SPY) ETF. But selling short requires a margin account and subjects you to a theoretically unlimited risk of loss, since stock prices have no defined upper limit to where they can trade. You could limit your risk with put options, but options are illiquid, time sensitive, and typically expire worthless. Going short or playing options are for experienced traders only.
What about so-called inverse ETFs? The ProShares Short S&P500 (SH) purports to move inversely to the daily price moves of the S&P500. From June 2006, when the ETF was introduced, through the end of 2010, the S&P 500 was essentially flat. Since there was no net change in value, the inverse instrument should have been essentially flat as well, right?
Wrong. SH fell 38% over that period. Inverse instruments only work over short-term time periods. Longer-term, they exhibit enormous tracking errors. The leveraged versions of these instruments are even worse.
Bottom line: Owning instruments tied inversely to the movement of stocks is a move only for seasoned, short-term-oriented speculators.
Candidate #2: Cash
Since stocks are denominated in U.S. dollars, by definition U.S. dollars (cash) should insulate you completely from any nominal declines in stock values. But that assumes that your dollars are in a safe place. And that depends on the banking system holding up (unless you’re hoarding actual paper bills in a home safe, in which case the risk of theft still exists).
The biggest problem with cash is that it will lose value in real terms over time as long as we have positive rates of inflation – something that’s virtually guaranteed by our monetary system. So while hiding out in cash certainly beats losing money in stocks, cash gives you no opportunity to actually gain anything and gives you the near certainty of losing to inflation over the long run.
Bottom line: There is nothing wrong with sitting on some cash temporarily while you wait for more favorable market conditions, but the longer you do, the more vulnerable you are to inflation.
Candidate #3: Japanese Yen
The Japanese yen currency may seem like an odd candidate to be a hedging tool for a potential stock market decline; but because the yen is used heavily in the so-called carry trade (in which traders sell the yen for leverage to go long on other assets), it often goes up when U.S. stocks go down.
The yen gained in 2002 and 2008 – both years when stocks tumbled. But it doesn’t always move inversely to stock prices, and since the yen pays essentially no interest, there’s little reason to hold it as a long-term investment. Japan’s debt as a percentage of GDP is even larger than ours, so a yen devaluation looms as a possibility, though it will likely take place gradually.
Bottom line: Less risky than shorting stocks, but not reliable as a hedge and not suitable as a long-term holding.
Candidate #4: Bonds
U.S. Treasury bonds have been in a secular bull market move for 30 years. During that time, they’ve performed relatively well when stocks have swooned. But bonds may have put in a major top in 2012.
If bonds have indeed peaked (meaning interest rates are set to continue to rise), then what’s worked over the past 30 years has to be thrown out the window. We could be entering an environment of rising interest rates and rising inflation, which contribute to lower equity valuations. If stocks start moving down in part because interest rates are rising, then fixed interest-rate instruments such as bonds cannot be expected to serve as effective hedges.
Bottom line: They may carry less volatility than stocks, but bonds’ best days are probably behind us.
Candidate #5: Utilities
The utilities sector is perceived as a safe-haven because of its relatively low volatility and generous dividend yields. Utilities can be a beneficiary of sector rotation. When investors move out of higher-risk sectors such as financials and technology, they may seek the relative stability of utilities.
Utilities – especially the ones that trade on foreign exchanges – have badly lagged the S&P 500 over the past couple of years. That makes them attractively priced from a valuation perspective compared to the market leaders. Richard Suttmeier, chief market strategist at ValuEngine.com, is bearish on the major market indexes and rates most stocks as overvalued. But he rates 90% of utilities as “buys.”
Now would seem to be an opportune time to switch from high-flying, overvalued sectors into something like iShares Global Utilities (JXI). The ETF’s globally diversified portfolio packs a 4.3% dividend yield and makes for a perfectly suitable long-term holding.
However, utility stocks aren’t exactly an ideal hedge if you are expecting a stock market crash. During major bear markets, utility stocks tend to get dragged down also – just not as severely as most other sectors.
Bottom line: Fine for a core holding; may not serve well as a hedge during a market meltdown.
Candidate #6: Precious Metals
What about one of the traditional crisis hedges, gold? In fact, gold is one of the least correlated assets to equity markets. It often rises when the stock market falls – or at least holds steady. Gold shrugged off the 1987 stock market crash and finished essentially flat for the month. Over periods of protracted bear markets in equities, gold prices tend to do quite well.
The table on page 4 shows how gold and silver performed during recent major bear markets for the S&P 500 and Nasdaq.
It appears that gold’s reputation as a doomsday metal is well deserved!
A lot of people have been frustrated by gold’s underperformance over the past couple of years. But in a way, it’s done just what you’d want it to do as a portfolio diversifier – it’s moved mainly in the opposite direction of the major stock market averages. If that inverse correlation persists, owning gold will pay off when stocks start heading south again.
As for silver, it’s more volatile than gold and, as an industrial metal, is more of an inflation play. If inflation starts picking up, we can expect silver to outperform gold. But silver is less reliable than gold during bear markets for stocks, when a bad economy can cause industrial demand for silver to suffer.
Bottom line: Gold offers both long-term inflation protection and refuge from bear markets in stocks.