We’re seeing more weakness in our Core Market Health indicators this week. As a result, we’re moving to 60% cash and 40% long in our Core Long / Cash strategy. As we noted yesterday, we don’t know where the market goes from here, but market internals are telling us to take caution and protect our portfolios until the internals become more healthy. Here is more information about how we hedge by going to cash. Our hedge strategies that use our market risk indicator went to cash or were aggressively hedged on 10/19/2012. The cash strategy is benefiting, while the aggressively hedged portfolio is currently paying for insurance as the time decay and lack of volatility are eating away at our hedges. Even with the small loss in the portfolio we’re comfortable with our current positioning especially since it doesn’t appear that anyone is looking at the headwinds we’ll face next year regardless of the fiscal cliff resolution. On the chart below the yellow lines are us raising cash. The thickness
Today we find ourselves watching a market that is in no man’s land. After topping in mid September the S&P 500 Index (SPX) suffered a mild correction falling from about 1475 to near 1350. Now it is attempting to rally and is caught between its 50 and 200 day moving averages. Everyone seems to be asking the same questions. Have we topped? Is the bottom in place? Where does the market go next? With that in mind, we thought it would be a good time to talk about a few of our most important observations about market tops over the last 30 years. The first thing we’ve noticed is that tops take a long time to form. They’re brutal to an investor who makes big bets using put options because of the time decay in their options while the market chops around, puts in marginal new highs, then chops around some more. Fortunately they’re a bit less painful for an investor using put options, volatility, or other aggressive financial instruments
Here at Downside Hedge we’re always interested in any hedging strategy. Although we’ve developed our own criteria for when and how we hedge our portfolios, we try keep abreast of ETFs and Mutual Funds that offer hedging strategies to individual investors. We understand that there are individual investors that aren’t comfortable building a portfolio hedge on their own by buying options, volatility, and shorting the market. For this reason our strategies don’t work for everyone. In addition, many investors like to diversify their money across more than one strategy in an effort to limit volatility in their portfolio. So we though it would be a good idea to do a small overview some of the alternatives we’ve found. If you know of any others, please let us know and we’ll add them to the list. Also, please note that we’re not recommending any of these funds. We just thought you should be aware of them. Hussman Funds Probably the most well known fund that offers hedging for an individual investor
Last week several of our core market health indicators strengthened a bit, but not enough to overcome the indicators that showed weakness. The net result was an overall weakening in market health. As a result, we’re raising more cash in our Core Long / Cash Hedge strategy. It is now 60% long and 40% in cash. Here’s more information on our Long / Cash hedging strategies. In the chart below the yellow lines represent raising cash and the green lines are adding exposure to the stock market.
Enough of our core indicators have weakened that our “core” Long / Cash Hedge strategy is now 80% Long and 20% in cash. Our core strategy ignores our Market Risk Indicator. As a result, it takes larger draw downs, but has better overall performance because it enters the market earlier in new rallies. If you follow our Market Risk Indicator you would have gone 100% to cash on 10/19/2012. You can see a comparison of the hedge strategies here. Below is the current chart for the core strategy. The green lines represent adding long stocks. The yellow lines represent raising cash.
Our Long / Cash hedging strategy is now 100% cash. Please see our Long / Short Hedging Strategy Update for an explanation. In the chart below the green lines represent buying stocks for the portfolio (reducing cash). The yellow lines represent raising cash by selling stock.
Our Market Risk Indicator closed the week in negative territory. This signal caused us to aggressively hedge our portfolio. We’re effectively 50% Long and 50% short, but our shorts consist of instruments that will benefit from increased volatility in the market. Some examples are puts against our long positions or mid term volatility like VIXM or VXZ. A lesser alternative would be an actively managed bear fund similar to HDGE. The long portion of our portfolio continues to be stocks that we believe will outperform the general market over the long run. This move in the portfolio is not a prediction of lower prices in the market. Rather, it reflects enough increased risk that we want to insure our portfolio. As we’ve noted before, our Market Risk Indicator has many false signals that are usually short in duration. If this signal is false we expect to take a small loss which we consider paying for insurance. If the signal proves to be correct we expect to make money as volatility
Our Long/Short Hedge strategy is now 100% net long. The break out above 1422 in the S&P 500 Index brought with it strength in enough of our indicators to get us fully invested on the long side of the market. Our long portfolio consists of stocks that we want to own over the long run. The current situation in our indicators has occurred several times over the past 12 years. Almost all of these instances were followed by multi-week (or month) rallies. We did have one occurrence in May of 2006 that was reversed one week later to an aggressively hedged position and resulted in a whip saw. Here are some examples of where we were 100% exposed to the market after coming out of a correction. July 2003, December 2005, May 2009, November 2010, and January 2012. We can’t see the future so we don’t know if this will be a good signal, but we follow where the market leads. On the chart above the green lines indicate adding
Our Long/Cash Hedge strategy is now 100% long stocks. For an explanation of current conditions see our Long Short Hedge Strategy update. On the chart below the green lines represent adding long exposure. The yellow lines represent raising cash.
Our Long / Short hedging strategy is now 80% long and 20% short. As the market consolidated above 1400 we saw improvement in most of our core indicators tracking market trend, risk, and strength. We’re still not seeing the strength we’d like in enough of our measures of the economy and market quality. Conditions such as we’re experiencing today are most likely associated with a continuation of an up trend after a correction. However, during a bear market these conditions occur near bear market rally highs. Our current Hedge Ratio is .25. The long portion of our portfolio continues to be stocks we want to own for the long run that we believe will out perform in an up trend. Our 20% offsetting short is simply a short of the S&P 500 Index. The green lines are adding exposure (removing shorts and increasing longs). Yellow lines represent increasing our hedging (reducing longs and increasing shorts). The red line signals aggressive hedging with instruments like puts, volatility, or actively managed bear