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
On 7/13/2012 our Long / Short hedging strategy moved from aggressively hedged (using put options, or an actively managed short fund like HDGE, or midterm volatility like VIXM or VXZ) to a full hedge using a short of the S&P 500 index. We’re still long 50% of the portfolio with stocks that we believe will out perform in an up trending market and short 50% using the S&P 500 index. When we’re in this position our expectation is that we’ll make money if the market moves higher (our long stocks should out perform). We expect to lose a little money if the market moves sideways or down…but that’s the price of insurance. The current hedge ratio is 1. On the chart below the green lines get wider as we add exposure. The yellow lines get wider as we remove exposure by adding hedges. The red line indicates an aggressive hedge.