Time for Some Hedging?
The economic calendar is extensive with a focus on housing and consumer behavior. Expect market participants to look for any sign that the economic recovery is stalling in the face of the COVID-19 surge and the slower pace of reopening. Unemployment claims data remains an especially important indicator. Second quarter earnings reports, beginning with the big banks, will also provide a closely watched perspective on the economy.
With so many worried about an economic stall it is natural to ask:
Is it time to do some hedging?
This week’s image is from Sportpunter.com, which takes a British, quantitative, and sports perspective on the hedging question. The image suggests that it is not as easy as it might seem.
Last Week Recap
In my last installment of WTWA, I drew upon the wisdom of Satchel Paige who counseled, “Don’t look back; something might be gaining on you.” Markets have reflected the perceptions of those focused on the most recent changes. The forward-looking quality depends on the accuracy of these perceptions. I did not really expect major media to follow this theme, since no one else is trying to measure and explain the linkages between the pandemic, the economy, earnings, and stock prices. I have been following my 2020 resolution of asking myself each week, “What is the most important thing for investors to think about?” I was delighted to see comments (and I read them all) from some of my most astute readers underscoring the importance of this approach.
The Story in One Chart
I always start my personal review of the week by looking at a great chart. This week I am featuring Investing.com’s version. This is just the static chart, but a visit to the post will enable you to explore the many news callouts and much more.
The market once again ignored record numbers of new COVID-19 cases to post a strong week. The market gained 1.8% with a trading range of only 2.3%. My weekly indicator snapshot monitors the actual volatility as well as the VIX (see below).
The weekly sector chart shows the source of the gains.
The “recovery” trade is doing well, reinforcing the market verdict on the coronavirus threat. Industrials, financials energy and materials are all part of that group. Defensive sectors like utilities, consumer, and health are weakening ang lagging.
Keeping in mind that each decade is different, this summary of the last ten years tells an interesting story. (Visual Capitalist Advisor Channel).
Each week I break down events into good and bad. For our purposes, “good” has two components. The news must be market friendly and better than expectations. I avoid using my personal preferences in evaluating news – and you should, too!
New Deal Democrat’s high frequency indicators have always been a valuable part of my economic review. They are especially important as we all try to monitor the economic recovery. His long-term indicators are positive mostly from low interest rates. The short-term indicators are positive, which NDD finds “perplexing”. The nowcast is beginning to reflect weaker consumer activity.
- ISM Non-Manufacturing for June spiked to 57.1, handily besting expectations of 49.0 and May’s 45.4.
As I have been noting every week, interpretation of any diffusion index is difficult. It looks good if a large number of respondents see things as even a little better than the prior month. The extreme volatility of the headline and subcomponents illustrates this problem.
- MBA Mortgage Applications increased 2.2% and remain strong when compared to other recent years. (Calculated Risk).
- Rail freight continues to improve but remains at low levels compared to a year ago. Steven Hansen’s (GEI) report of the economically intuitive sectors provides a good picture.
- JOLTS for May showed 5.397M job openings, more than April’s 4.996M. This is the portion of the report the major media reports, so we’ll score it as “good.” I do not find it very helpful right now since it is not the best measure of job growth. When indicators stray far from the normal range, making inferences is dangerous. The number of “quits” is viewed as a “measure of workers’ willingness or ability to leave jobs. In May, that number was 2.1 million, up 190K while layoffs were 1.8M, down almost 6 million from April. (BLS).
Also, please compare the reported “quit rate” with this current survey result.
- Initial jobless claims of 1.314M were better than the expected 1.35M and the prior week’s 1.413M.
- Continuing jobless claims of 18.062M were lower than the (downwardly revised) 18.760M of the prior week.
- PPI for June declined 0.2% rather than the expected gain of 0.4%, which was also May’s result.
- Core PPI for June declined 0.3% rather than the expected gain of 0.1% and lower than May’s -0.1%. I continue to treat low inflation data as “good” since it leaves room for aggressive monetary and fiscal policy. Some observers cheer for higher inflation, mostly because it is associated with economic growth. There are better ways of analyzing growth.
- Made in China? The early-week rally was supported by Chinese government encouragement to buy stocks.
- Heavy truck sales for June are down 42% year-over-year (Calculated Risk).
- Johnson Redbook same store sales have stalled at low levels.
- The Oxford Economics Recovery tracker, combining many sources, has also flattened out. Please note that the report is for 6/26.
- US Vehicle sales rebounded from Great Recession levels but remain far from normal.
- Covid-19 surge is affecting consumers’ comfort level.
The latest COVID-19 surge. There are many pandemic trackers, but the ProPublica project on reopening America has some very attractive features. The image here is static. If you go to the site and move the date slider you will see the image for that date. The arrow for my new state, Arizona, for example was flat on May 24th. Now the indicators are the worst in the country. Check out your own state’s progress (or lack thereof) and see where the big moves are.
The Week Ahead
We would all like to know the direction of the market in advance. Good luck with that! Second best is planning what to look for and how to react.
There is a busy calendar, including some important reports. Housing starts and building permits are a special focus for me. We will closely watch retail sales to see if last month’s big gains can be sustained. Industrial production, important for GDP calculations, is expected to increase smartly. Jobless claims data remain the fastest read we get about the employment situation. There is a big gap in expectations for the CPI, but it is unlikely to move markets. The regional Fed reports (diffusion indexes) are even less interesting than useful. Michigan consumer sentiment might provide some forward-looking information.
The second quarter earnings season kicks off with reports from the big banks. The expected decline is likely to be the largest in history on a year-over-year basis – 44.6% (FactSet). Brian Gilmartin is watching for adjustments in forward earnings as the results come in.
Expect market participants to watch the COVID-19 surge and for any signs that it has affected the economic data.
Briefing.com has a good U.S. economic calendar for the week. Here are the main U.S. releases.
Next Week’s Theme
The economic news, once again, got better, and pandemic news, once again, got worse. This week’s calendar provides some insight into whether the slowing pace of the Great Reopening is showing up in the data. Earnings reports will provide the company perspective, although fewer are providing explicit guidance these days. With growing concern about a stall, it is natural to wonder:
Is it time to do some hedging?
There are books on this subject, of course, so my approach will be focused. I am addressing individual, long-term investors who want to keep it simple. I will take up whether there is a need to hedge, the most prominent choices, and the likely costs. This is obviously a decision that should be based on personal needs, but I will mention what I am doing myself and for clients.
Need to hedge?
If you are confident about the course of current public policy, then perhaps you do not need to hedge. Scott Grannis emphasizes the lack of new deaths. He cites a source on who the victims are: “For people younger than 45, the infection fatality rate is almost 0%. For 45 to 70, it is probably about 0.05%-0.3%. For those above 70, it escalates substantially.” He also is comforted by “vaccine solutions are on the horizon, and a recent hydroxychloroquine study showed a 50% reduction in hospital mortality rates. Remember, you first heard about HCQ here in late March.”
Here is a little quiz to see if you share Grannis’s confidence.
- Are you confident that the COVID-19 mortality risks are near-zero for young people?
- Do you expect younger people to cooperate in social distancing and tracing to avoid exposing older family members?
- Do you expect government bodies to find the risk to older citizens in the acceptable range?
- Do you expect public fear to decline enough to support an early return to work and to recreation?
That is not close to a complete list, but it gives you an idea. Weakness on any of these points extends the length of the recession.
The other aspect of needing a hedge is the size of the risk. Here are some perspectives:
David Templeton (HORAN) analyzes the ETF and mutual fund flows, showing the exit from stocks. While this (eventually) is a contrarian signal, it does not say much about the near-term outlook. He is also interested in corporate guidance.
The WSJ discusses the same trend, wondering whether these investors will miss the rally. Will they know how to re-enter markets?
Paul Schatz wonders, Is the NASDAQ 100 the New Dotcom Bubble? Not yet, he concludes, but piling into a few stocks is “dangerous behavior that can lead to consequences tomorrow, next month or next year.”
Eddy Elfenbein is attentive, but he does not see a bubble. He also highlights the importance analyzing stocks as well as ETFs or the market.
If you feel like you’ve seen this movie before, you’re not alone. This is somewhat similar to what happened 20 years ago when the Dot-Com Bubble and Bust turned Wall Street upside-down. The difference was that that case was, to use a technical term, totally bananas. This time, it’s merely worthy of attention.
In this week’s issue, I want to discuss the dangers of a divided market, because that’s exactly what we’re seeing. On Wall Street, a rising tide does not lift all boats. I’ll break down what it means for us.
Jesse Felder highlights a Scott McNeely quote from the aftermath of the Dotcom bust:
At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?
That seems pretty persuasive all right, from an executive who saw just that happen to his own stock, Sun Microsystems. Is there a relevant lesson for today?
Even more interesting, however, may be the fact that only a few months ago there were even more companies within the S&P 500 Index that trade above this “ridiculous” valuation level than there were back in 2000 (thank you Tobias Carlisle and AcquirersMultiple.com for providing the data). What’s more, even as we find ourselves in the midst of the worst economic crisis in modern history, there are still more stocks that trade above 10-times revenues today (37) than there were in March of 2000 (30), the month the Nasdaq put in its infamous peak before falling 75% over the subsequent two years.
My own calculations show limited upside unless we have a robust economic recovery. The downside has a base case decline of 15% and 45% in some scenarios. Yes, I know. I need a full post on this topic a favorite for Mrs. OldProf, usually when she is watching the nightly news.
There are many choices for hedging. Richard Bowman covers 10 Ways to hedge your stock portfolio to reduce market risk. Read the post to see them all, but only some will interest the average long-term investor.
- Cash. This is an easily understandable choice. It reduces position size to your comfort level. You can calculate some estimated worst-case losses.
- Diversification. This is a popular choice, supported by academic research as well as experience. It does not mean that you can just buy any alternative assets.
- The asset must have an expectancy of a positive return. Cash, for example, reduces risk but is not diversification.
- It must be uncorrelated or (better yet) negatively correlated with what you are trying to hedge.
- Short selling. This hedge generally meets the negative correlation test, but be careful about size.
- Inverse ETFs. These allow investors who cannot engage in short selling accomplish the same ends with an ETF purchase. These are more complicated than they seem. It is important to study the prospectus as well as the record of tracking error. If you do not understand what that means, this product is not for you.
- Puts. Buying puts is the simplest and most direct options hedge. Put prices vary with the demand. It is important to analyze your costs and take what the market is offering.
There is no free lunch in hedging. Barron’s considers various choices. Often the cost is a matter of missing out on the possible upside, but let’s concentrate on out-of-pocked costs.
The cost of put protection has increased since the start of the year.
A big hurdle now is the cost of protection. Shepard says that put prices imply a one in 10 chance of another 20% decline in stocks over the next three months. That is three times higher than at the beginning of 2020. It also means that if you buy puts, you would pay a steep premium to protect against “tail risk,” or an event with a small likelihood of happening.
“If you bought puts in January, you probably did well,” he says. “But even in a normal market environment, puts have become very expensive.”
And what is the cost now?
Some advisors agree that puts are too pricey to be worthwhile. Richard Saperstein, chief investment officer of advisory firm Treasury Partners, calculates that put protection against the S&P 500 today would cost investors an annualized 6.6%.
Moreover, the market would have to decline by 16.6% before an investor would break even on the put (since the first 10% decline wouldn’t be covered by the cost of the put, in this example).
“The cost of hedging is quite elevated,” Saperstein says.
Whether the cost is “elevated” depends upon your personal assessment of risk and the value of some protection.
My own reaction to elevated risk has been to reduce the size of portfolios and focus on stocks which I expect to hold up well regardless of conditions. My homebuilder positions, for example, have a built-in hedge. They do well when interest rates move lower, a normal feature of economic weakness. Biotech positions have also done well during the pandemic. I am up on the year despite the significant cash holding.
Some clients also participate in programs that provide value-added diversity. These clients have also enjoyed YTD gains.
Finally, I provide specialized put positions for clients who find that attractive. The cost of put protection is not as high if it is not a permanent position. Put another way, it helps to have some knowledge about events and the market reaction.
Inexpensive hedging is possible for those who understand the principles in this post.
Ideas for Investors
I have decided to switch the investor section to a separate post. I hope to run it nearly every week, calling it Investing for the Long Term. In the latest edition I expanded my matrix approach for finding long-term value drawn from our most recent Wisdom of Crowds survey. As usual I linked to several of my favorite sources for investment ideas. In each case I added a comment about how I might use the idea and also related it to our Great Reset results. I hope readers will find this valuable and that my colleagues will consider the Great Reset Matrix as part of their selection process. My next installment will apply this analysis to the ideas in the Barron’s mid-year roundtable.
One of my personal 2020 resolutions was even more emphasis on investor education – not just recommending stocks but learning how to find suitable choices. I have created a resource page where you can join my Great Reset group. You will get updates about what is being studied and can join in the process. There is no charge and no obligation, but I hope you will join in my Wisdom of Crowds surveys. I need more wise participants! The latest survey results are part of my most recent report. The results of our team effort will be published on a regular basis, so you will be joining me in contributing to a greater good.
Quant Corner and Risk Analysis
I have a rule for my investment clients. Think first about your risk. Only then should you consider possible rewards. I monitor many quantitative reports and highlight the best methods in this weekly update, featuring the Indicator Snapshot.
For a description of these sources, check here.
The C-Score remains at levels never before seen. It is combining the sharp economic rebound with pandemic effects. When we are able to separate the two, a current mission of Dr. Dieli, it will provide more guidance on the timing and extent of the recovery. I continue my rating of “Bearish” in the overall outlook for long-term investors. We should also keep watch an inflation antcipation. As this increases it affects government policy and our portfolio construction needs.
The Featured Sources:
Bob Dieli: Business cycle analysis via the “C Score”.
David Moenning: Developer and “keeper” of the Indicator Wall.
Georg Vrba: Business cycle indicator and market timing tools.
James Picerno discusses the Fed’s consideration of a yield curve control (YCC) policy. He reviews the pros and cons and the possible reason for action. This decision would naturally affect an indicator that many of us use to gauge the business cycle. Stay tuned!
There are a few more hedging concepts to keep in mind.
- What are we hedging? It is more than just concern about a market decline. Market volatility by itself is the friend of the long-term investor, offering chances to buy and to sell and attractive prices. I am focused on a decline that is linked to the economic effects of the pandemic. I do not expect this concern to be relieved until there is a balanced approach to reopening the economy.
- A hedge requires management. When do you change the size or take it off completely? (The article cited with this week’s image discusses that matter in detail).
- Hedging must be done in advance. Waiting until it is obviously needed is a big mistake. Whatever signal you are using is followed by many others. The 1987 market crash came from a “portfolio insurance” concept that sold futures contracts as stocks declined. Since there was an obvious arbitrage, futures selling dragged stocks down as well. And no, this was not caused by futures. It was caused by investors who had a poor plan with inadequate understanding of the relationship between markets.
- Do not expect to make a profit from your hedge. That would be like cheering for your house to burn down to verify the wisdom of buying insurance.
- Do not expect a free lunch from a fancy “structured note” or annuity. Anything in those contracts can be replicated by an options professional. The cost is lower, liquidity is better, and you need not depend on the solvency of the issuer.
And finally, adopting a hedged does not require a forecast of the future.
You are identifying a possible outcome that represents unacceptable risk. It is wise to deal with risks.
I’m more worried about
- Continued lack of progress among leaders. The timing of this crisis, in the homestretch of the election season, is a special challenge.
- Natural disasters. Always a challenge, but even more so without a lot of close contact in helping victims.
I’m less worried about
- China and trade. At least there are some branches extended.
- Perceived lack of a managed scientific strategy for fighting the virus. (Stat). I don’t like politicians pontificating on science. Scientists claiming to know organization theory is just as bad. Do they really believe that a central controlling organization would be the best way to innovate?