Hedging Market Exposure

[twacowfca]

A few days ago when the S&P 500 was near the record high, we hedged our portfolio buy purchasing  slightly OTM puts.  Today, these OTM puts are now significantly ITM, and we added a straddle to the hedge by purchasing OTM S&P 500 calls.

 

The net effect is that we will continue to be more than fully hedged if the market continues to go down. If the market is flat, we will have a small continuing expense with time decay.  If the market pops back up, the OTM calls that were bought for pennies, about 12% of the current value of the puts,  means that we won't lose money on what we paid for the puts.  :)

[twacowfca]

A few days ago when the S&P 500 was near the record high, we hedged our portfolio buy purchasing  slightly OTM puts.  Today, these OTM puts are now significantly ITM, and we added a straddle to the hedge by purchasing OTM S&P 500 calls.

 

The net effect is that we will continue to be more than fully hedged if the market continues to go down. If the market is flat, we will have a small continuing expense with time decay.  If the market pops back up, the OTM calls that were bought for pennies, about 12% of the current value of the puts,  means that we won't lose money on what we paid for the puts.  :)

 

After The Fed's announcement today at 2:00PM that they are continuing with their plan and are reducing their bond purchasing by an additional $10B per month, we sold the calls we bought earlier today at a small loss.  Now we're back to square one, continuing to own the companies in our portfolio that we like to hold, but with puts on the whole market that more than hedge our portfolio, and could give us a huge pile of cash to deploy if there is a big sell off.

[Cardboard]

I posted my ideas relative to hedging in a different post earlier today but, a simple question for you Twacowfca: what is going to be the ringing bell to tell you to get out of these puts?

 

My impression and maybe that I am wrong, this is no different than market timing.

 

Cardboard

[twacowfca]

I posted my ideas relative to hedging in a different post earlier today but, a simple question for you Twacowfca: what is going to be the ringing bell to tell you to get out of these puts?

 

My impression and maybe that I am wrong, this is no different than market timing.

 

Cardboard

 

Guilty as charged of  the offence of market timing.  Our record is about 50 : 50 when predicting minor adjustments in the market.  On the other hand, it has been accurate in predicting large shifts, although not precisely perfect in predicting the precise date of major turns in the market.

 

However, my confidence that the market is on the verge of being scared by the sight of a bear is much lower now than it was in the first half of 2000 or last half of 2007.  There aren't as many excesses now as then.  On the other hand, except for market memory, which seems to have a limit of about four years, and strong momentum until recently, there are lots of factors that could pinch increasingly going forward.

 

The big Kahuna is where the market goes the last two days of January.  if the market is significantly down in January, and down in the first week in January as it was this January, history shows that it will be down for the whole year 90% of the time.  There is reason to suspect that this effect is not entirely an extreme random fluctuation.  in any case, it has a powerful psychological influence that may tend to become a self fulfilling prophecy.

 

My confidence level that a substantial decline is in prospect will increase greatly if the

market close Friday continues to be down at least one or two percent from the EOY close.

 

All things considered, it seems appropriate to hedge rather than to cash in our low beta portfolio of great businesses ( more accurately, our low down volatility portfolio ).

[jay21]

I saw a bullish note from Citi I believe and they posed an interest conundrum for primarily HY fixed income investors and an interesting bull argument.

 

They note valuations are stretched extremely thin leaving barely any room for price appreciation.  But what do you do if you need to be fully invested? They said no imminent defaults are projected so they suggested getting a year of carry.

 

Seems like a horrible risk/reward to me.  I don't think hedging here is a bad idea if that's the bull case.

[SpecOps]

The sophistication of my 'hedging' only extends as far as increasing cash. And that is not really a top down decision I take its just a result of not finding enough good ideas.

 

I read of someone wiping out their 2013 portfolio performance by hedging the market so that has put me off the idea tbh.

[Phoenix01]

In December I finally was able to dedicate a few days to screening the market and I was looking for some nice long positions.  After searching for days, the cheapest company I could find was twice the price I was willing to buy 5xFCF+Cash-LTD.  I did not realize that the market had run away so far and broadly, so I spent the next few days trying to figure out what was going on.

 

Dedier Sornette puts out a compelling argument that the bull market will end in Dec 2013 or Jan 2014.  Harry Dents has his view of demographics causing the markets to go over the cliff in 2014.  FFH is selling equities and putting the gains into buying higher strike puts.  The VIX is really low, the market are all high.  ValueLine shows that we are at record valuations.  And the list goes on and on and on.

 

In response to this, I sold almost all of my long positions except for FFH and I started to buy deep OTM puts on the most leveraged companies that do not have the FCF to pay down the debt.  Since I did not have the luxury of time to research the companies, I took a basket approach and bought puts in over a dozen companies.

 

I do not know when the market will correct itself or what the catalyst will be, but the possibility is not negligible and the outcome could be disastrous for those that are not protected.  My plan is to keep focusing my energy on identifying the best puts and buying them on market increases and rotating out of the weaker puts when the markets drop.

[Straddle]

In response to this, I sold almost all of my long positions except for FFH and I started to buy deep OTM puts on the most leveraged companies that do not have the FCF to pay down the debt.  Since I did not have the luxury of time to research the companies, I took a basket approach and bought puts in over a dozen companies.

 

I tried the same on CZR (lots of leverage and poor cashflow), but the puts just kept expiring OTM and I lost everything I paid for them. I'm not going short this time, as long as everything goes further up I'll stay with my stock positions. I don't think one should be bearish now, only careful.

[frommi]

Only because you couldn`t find an investment that fits your criteria doesn`t mean the market crashes tomorrow (Perhaps your criteria is too strict?). We are far away from bubble territorium like in 2000. Some equities like TWTR, FB or AMZN are surely mispriced, but when you look at the S&P these companies make only a very small portion of the index. You can get KO or PEP for around 19/20 P/E, in 2000 the P/E was around 40-50. And back in 2000 you had really good hedges available in 10 year treasuries or cash yielding 6%. Compare that to today, you can hedge with cash (0%), bonds (2.7%) or puts (-100%). There is no reason to hedge in this environment, simply because there is no cheap asset class for a hedge available. Even gold is far away from the long term average inflation adjusted (<800$). Bond funds had the greatest outflows of the last decade in 2013, this money sits there in cash. Meanwhile the pressure to buy equities gets higher and higher, because this money doesn`t earn a return. And now imagine you pulled your money out at 2.7,2.8 or 2.9% of 10 year treasury yields, would you invest it back in bonds at the same rates? Surely not. Perhaps it flows back when we reach 4%, but not that much earlier. Under these circumstances the worst outcome for stocks is that we go sideways for a long time in the market, while the interest rates slowly climbs up.

 

There are always opportunities in the market especially for a small investor. At the start of the year REITs where not that expensive and you could get some with a possible forward return of 15%. They were a good hedge against the market correction in january in my portfolio, but i wouldn`t have called it a hedge at the start of the year. :)

[stahleyp]

frommi,

 

I'd be careful about comparing valuations to 2000. The market has crashed plenty of times with 2000 like valuations. 2008, 1987, 1974, etc.

[frommi]

frommi,

 

I'd be careful about comparing valuations to 2000. The market has crashed plenty of times with 2000 like valuations. 2008, 1987, 1974, etc.

 

data from multpl.com:

 

1/1/1974: earnings yield s&p500: 8.56%, 10y treasury yield: 6.99%  equity premium = 1.57% or 22% over treasury yields.

1/1/1987: earnings yield s&p500: 5.55%, 10y treasury yield: 7.08%  equity premium = -1.53% or negative against treasury yields.

1/1/2000: earnings yield s&p500: 3.44%, 10y treasury yield: 6.66%  equity premium = -3.22% or negative against treasury yields.

1/1/2008: earnings yield s&p500: 4.66%, 10y treasury yield: 3.74%  equity premium = 0.92% or 24% over treasury yields.

 

today: earnings yield s&p500: 5.13%, 10y treasury yield: 2.75%  equity premium = 2.38% or 86% over treasury yields.

 

Yes it has crashed with 2000 valuations but we are far away from that today. My point is that you can not look at valuations alone, you have to look at the "risk free" rate, too.

[Vish_ram]

It is not just the risk free rate, but the shape of the yield curve that seems to predict recession and stock market crash.

 

check out this link

http://www.newyorkfed.org/research/current_issues/ci2-7.pdf

 

I see that fed engineered braking of economy results in recession (with yield curve inverting) & subsequent market crash, are the easiest to predict. The recession due to supply shock are more random and harder to predict.

 

 

[stahleyp]

frommi,

 

Good points and thanks for the perspective. By the way, in my other post I meant to say "without" 2000 type valuations that the market has crashed, not with it. Sorry about any confusion.

 

As Klarman said back in June, "there's no such thing as a free lunch in economics." If all we have to do is print lots of money without severe negative consequences, that is a free lunch. In Antifragile, Taleb talks quite a bit about how if you protect a system too much it becomes weaker since there aren't enough failures to keep it strong. We're not really allowing failures now.

 

With all that being said, I'm almost fully invested but have been moving slowly (very slowly) to cash with new funds. As the famous Buffett quote goes, you want to be greedy when others are fearful and be fearful when others are greedy. I don't think we're quite yet to the greed part, but we are getting closer.

[ERICOPOLY]

As Klarman said back in June, "there's no such thing as a free lunch in economics." If all we have to do is print lots of money without severe negative consequences, that is a free lunch.

 

 

The negative consequences may have already happened.

 

A credit bubble produced inflation.  Popping it should have produced deflation.  So left to it's own course, the negative (inflation) from the credit bubble would have been (at least partially) reversed.

 

Printing lots of money (perhaps) prevented the reversal.  Therefore, there's your cost!

 

So no free lunch.

 

There may be worse consequences yet to come, but cementing in the already-incurred inflation cannot be ignored either.

 

And for those who hate deflation, this is one case where a negative is a positive.  It's therefore entirely possible that money printing can have a positive effect without a "negative" consequence, while at the same time produce inflation.  It has the illusion of calm before the storm (inflation offsetting deflation), but that calm is perhaps the storm itself.

[stahleyp]

Eric,

 

Perhaps you're right. I just don't know though, man. Usually, if something is too good to be true, it usually is (but not always). And you give a plenty of rational reasons why that might be the case (thanks for challenging me). I suppose we'll see over the next couple of years. If you ever get pretty bearish, don't keep it to yourself (please!). ;)

[ERICOPOLY]

I'm not saying there won't be a huge negative future problem, but just stating there doesn't have to be one (and the lunch would still not be free).  Clearly not printing would have been bad too -- lot's of deflation. 

 

Didn't you see Space Cowboys where they landed the shuttle without the computers?  It can happen  :)

 

I was a bit disappointed that Klarman made the "no free lunch" comment without recognizing that every day without deflation from this huge credit collapse, we are in fact incurring inflation from the money printing.

 

It was a pretty major collapse after all.  It's not like every dollar of money printing is still left to hit us -- how much is left, we don't know.  Prem seems to believe deflation is still in store for us.  So there you go, maybe not enough money printing.

[finetrader]

It looks like Fairfax are always 3-4 years too early in starting their hedge position.

So considering this it might be a good idea to start a hedge program.

I did hedge a portion of my portfolio in 2013 ( about 25-30% on occasion) and it probably cost me 2-3% gain on my portfolio.

 

Now I'm hedged about 40% of portfolio.

I think my positions (C,BAC, AIG) are all trading at about P/E=10 while I short an index (S&P 500)  trading at about P/E=15-17. So I think I can outperformed this index.

 

And yes I'm a little worried about China

[stahleyp]

I have not seen Space Cowboys! haha

 

On the bright side, Harry Dent has another book out. Admittedly, that tends to be a good contrarian indicator.

 

http://www.amazon.com/Demographic-Cliff-Survive-Deflation-2014-2019-ebook/dp/B00H4PINJE

[ERICOPOLY]

It looks like S&P500 trades at about 15x forward earnings estimates.  That's pretty normal I believe as long as the earnings continue to meet estimates.

 

So, I think to say the market is in a bubble is the same as saying the earnings are in a bubble.  So why not just go ahead and say what you mean.

 

Then, where is the imbalance.  Too much housing being built?  Too many autos?  What?  Where is the false demand? 

 

Which way is credit blowing?  I read Wells Fargo is dipping back into subprime again -- but it's the beginning of that phase.

[stahleyp]

A little more background on Dent. To be fair, he was right once or twice about 20+ years ago.

 

More recently, things look different. He published a book in 1999 called the "Roaring 2000s" A bullish book with a bearish outcome.

 

In 2006, "The Next Great Bubble Boom" bullish book with a bearish outcome.

 

In 2009, "The Great Depression Ahead" a bearish book with a bullish outcome

 

In 2011, "The Great Crash Ahead" a bearish book with a bullish outcome

 

And now, "The Demographic Cliff: How to Survive and Prosper During the Great Deflation of 2014-2019" a bearish book with a yet uncertain outcome.

 

If the trend continues, that bodes well for the markets.

 

 

I think Klarman's idea is that if the economy is so sick that we need all the stimulus, earnings would also crash without the "drug." This is a big experiment. It might work and it might not.

 

I don't know if earnings are in a bubble. However, if with all the stimulus and government spending is providing the basis of those earnings and if it stops, that could pop the earnings bubble, if one exists.

[ERICOPOLY]

I think Klarman's idea is that if the economy is so sick that we need all the stimulus, earnings would also crash without the "drug."

 

 

Sure,  but did he get that idea from Bernanke?  Of course the economy would crash without the drug.  That's the whole point of taking the drug.

 

The sickness is deleveraging.  The sickness will pass.

[mcliu]

 

A credit bubble produced inflation.  Popping it should have produced deflation.  So left to it's own course, the negative (inflation) from the credit bubble would have been (at least partially) reversed.

 

 

That's how I've viewed it as well, there should have been massive deflationary pressures, but the monetary stimulus has offset that.

 

Despite that, the situation still feels a little precarious as the Fed is walking a very fine line. Too little stimulus and deflationary pressures increase again while too much stimulus may get out of hand.

[stahleyp]

If it really is that simple, I wonder why guys like Watsa and Klarman  don't understand that? Perhaps they thought it would get worse and it didn't and now they're  suffering from the some type of bias. 

[ERICOPOLY]

If it really is that simple, I wonder why guys like Watsa and Klarman  don't understand that? Perhaps they thought it would get worse and it didn't and now they're  suffering from the some type of bias.

 

Those two men are not in agreement with each other.

 

Watsa has deflation hedges and Klarman has inflation hedges.

 

So, why don't they understand each other?

[steph]

frommi,

 

I'd be careful about comparing valuations to 2000. The market has crashed plenty of times with 2000 like valuations. 2008, 1987, 1974, etc.

 

data from multpl.com:

 

1/1/1974: earnings yield s&p500: 8.56%, 10y treasury yield: 6.99%  equity premium = 1.57% or 22% over treasury yields.

1/1/1987: earnings yield s&p500: 5.55%, 10y treasury yield: 7.08%  equity premium = -1.53% or negative against treasury yields.

1/1/2000: earnings yield s&p500: 3.44%, 10y treasury yield: 6.66%  equity premium = -3.22% or negative against treasury yields.

1/1/2008: earnings yield s&p500: 4.66%, 10y treasury yield: 3.74%  equity premium = 0.92% or 24% over treasury yields

 

today: earnings yield s&p500: 5.13%, 10y treasury yield: 2.75%  equity premium = 2.38% or 86% over treasury yields.

 

Yes it has crashed with 2000 valuations but we are far away from that today. My point is that you can not look at valuations alone, you have to look at the "risk free" rate, too.

 

This is the famous 'Fed Model' Greenspan loved so much to justify high stock market prices. But if your risk free rate explodes the stock market suddenly becomes expensive.

 

Or you should try to sell this to a Japanese investor ;) his equity premium has been great for the last 15 years and the market only went one way...down.