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Softening Hedge

Our Market Risk Indicator cleared its warning this week. However, our core measures of market health are still mired in negative territory. As a result, we’ll be softening the hedge in the hedged portfolio and staying 100% in cash in the long/cash portfolios.

To soften the hedge we’re removing put options and/or volatility products. For the model portfolio we’re selling ETFs or ETNs like VXZ, VIXM, or XVZ and replacing it with at short of the S&P 500 Index (you can use the symbol SH). The end result is a portfolio that is roughly 50% long stocks we believe will outperform in an uptrend (high beta stocks are likely candidates for the hedged portfolio) and 50% short the S&P 500 Index.

Below is a chart with the changes in our portfolio allocations over the past year. Green lines represent adding exposure, yellow lines are reducing exposure (and adding SH as a hedge), red lines are market risk signals where the hedged portfolio uses instruments that benefit from increasing volatility as the hedge. The thickness of the line represents the size of the allocation. You can see general information about the hedged portfolio here and details of our portfolio allocation changes in the past here.


As I noted earlier in the week this signal represents a whipsaw for our market risk indicator and the hedged portfolio allocations. Whipsaws in the indicator are common so we only use it for hedging or a long/cash signal. On this particular whipsaw a model portfolio would have either gained a fraction or lost about 1.2% depending on the instrument used to hedge. I look at it as the price I pay to protect myself from large draw downs.

Below is a chart with our current market health category readings (normalized to a scale of -10 to +10).


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