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Why I Am Hedging My Portfolio With UVXY

Summary The stock market is hovering near all time highs. The current bull market at 6 years is approaching the historical average. The VIX Index has not closed a month over 30 in more than 3 years. I usually stay away from investments that do not have tangible asset backing, but I have made an exception in the case of the Pro Shares Ultra VIX Short Term ETF (NYSEARCA: UVXY ). Perfect Portfolio Insurance What exactly is UVXY? According to its prospectus on the Pro Shares website, it seeks daily investment results that correspond to 2x the daily performance of the S&P 500 VIX Short-Term Futures Index. What this basically means is that this ETF rises and falls with the level of the VIX, which is more commonly referred to as “The Fear Index.” With general market levels at all time highs, there is not much fear permeating today’s business landscape. However, as market historians have learned time and again, fear is one of the most powerful human emotions, and can skyrocket at a moment’s notice. Let’s look at some of the possible reasons why the VIX could increase dramatically in the near future. The VIX Is Below Its 20-Year Averages Take a look at the following 20 year chart for the VIX: ^VIX data by YCharts As you can see, the VIX hasn’t closed a month above 30 since November of 2011, over 3 years ago. The VIX has risen to 30 or above on 10 different occasions throughout the past two decades, leaving us with an average of one spike above 30 every two years. The longest time the VIX remained below 30 was 3/31/03-9/30/08, a period of 5.5 years. Although this was a long wait, the VIX jumped all the way to its 20 year high of over 65 shortly thereafter. An era of low fear can only exist for so long in the volatile world of the stock market. This current run of low VIX readings is the second longest of the past two decades, and the longer that it continues, the higher the probability of a spike, based on historic averages. The Current Bull Market Is Almost 6 Years Old As a student of the stock market, I am fascinated by the bull and bear trends that are the fabric of investing. Although hindsight is always 20/20 in the stock market, the current trend is approaching the historical average bull market length. The longer that the market keeps running, the harder the inevitable fall will become. Since the 1950s, there have been 9 bear markets , which are defined as a drop in the S&P 500 by 20% or more from its high point. That leaves us with roughly one bear market every 6.5 years. The current bull market began in March 2009, which makes it almost 6 years old. The longer that this bull market runs past its historical average, the higher the likelihood that it will sell off and become a bear market. Current Statistics Indicate An Overvalued Market I’d love to say that I can predict exactly when the correction will happen, but I know that is a fool’s errand. I just know that the longer a trend continues in the stock market, the more people believe it to be true, which is ultimately when the sentiment changes. Robert Shiller, a renowned economist, created the Cyclically Adjusted Price-Earnings (CAPE) ratio in an effort to create a gauge of how expensive the current market is. It is tallied by dividing price by the 10 year moving average of earnings, adjusted for inflation. Check out the following historical CAPE chart for the S&P 500: S&P 500 Cyclically Adjusted Price-Earnings Ratio data by YCharts As you can see, we are currently at the same level that we were at during the peak of the 2008 market, and just under the level of the infamous 1929 crescendo. This does not mean that a crash is imminent, but it does mean that we are entering dangerous waters. Another tell tale sign of a roaring bull market is high speculation on margin. This chart shows an eerie correlation between stock prices and margin levels: (click to enlarge) Source: Business Insider As the famous Mark Twain quote goes, “history doesn’t repeat itself, but it does rhyme.” As stock prices keep increasing, people become more confident, and overextend themselves. It is a reality of the stock market today. Unless we are truly entering a fairy tale era of high margin speculation and never ending growth, this trend has to reverse itself eventually. Other Considerations The Federal Reserve has officially ended its unprecedented QE program, which has been the largest economic stimulus in world history. This is important because it is now only a matter of time before the Fed raises interest rates. It will be fascinating to see how the financial markets react to the inevitable rate hike. This will negatively impact earnings for thousands of companies that rely on borrowed money. When this happens, volatility will spike. From a macro perspective, it is a harsh reality that there is a tremendous amount of uncertainty in the world today. With Greece teetering on the edge of default and ISIS being in the news almost daily, there is high potential for a negative trigger sometime in the near future. Unfortunately, subprime lending is making a comeback and student loan debt is burdening an entire generation, causing first time home buyer rates to drop to 30 year lows . As the student loan generation ages, they will have less disposable income to spend, and thus will impact the revenues of many companies. All of these are potential catalysts that could trigger a long overdue negative reaction in the stock markets. Why Choose A Leveraged Fund? The reason I chose a leveraged ETF like UVXY rather than a standard futures ETF like the iPath S&P 500 VIX Short Term Futures ETF (NYSEARCA: VXX ) is simple: a strong conviction that the facts mentioned above will contribute to a market volatility higher than current levels in the near future. UVXY attempts to return 2x the VIX’s performance for that particular day. This means that when a spike in volatility occurs, UVXY will significantly outperform VXX, which only attempts to achieve 1x the VIX performance. Although UVXY will decline more than VXX in a low volatility market, the increased profit potential outweighs that drawback in my opinion. Risks There is one dominant risk concerning this strategy: the structure of UVXY itself. UVXY is a leveraged futures ETF, which means that it suffers exponential decay when in a period of contango. Contango is when the futures price is more expensive than the current spot price. Unfortunately, in a low volatility market like the present one, UVXY is in contango the majority of the time. Accordingly, the risk of holding UVXY for a long period of time should be obvious. It WILL lose money if the market keeps up its slow ascent and fear fails to materialize. However, history shows us that record high stock prices and low volatility cannot go on indefinitely. It is of utmost importance to exit a position in UVXY as soon as the VIX spikes in a significant way. Why is this? Because fear is a much stronger emotion than greed, but lasts for a much shorter time, which makes the spikes that much more pronounced. Accordingly, fear can vanish in an instant, so huge gains in a vehicle like UVXY can vanish in the blink of an eye. Conclusion Although the near future in stocks may continue to be bright, I believe that preparing for the worst is always a good strategy. As a holder of equities, I am hoping that the stock market continues its upward trend, but I will be prepared if it does not. I consider the decay of UVXY the monthly premium that I pay in order to hold insurance in the case of disaster. If any of the aforementioned negative triggers materialize, UVXY should increase in value, which will then allow me to add to my long positions at lower prices. As Warren Buffett is famously quoted: “Only when the tide goes out do you realize who’s been swimming naked.” All I know is that when the wave of fear hits, at least I’ll have my bathing suit on. Disclosure: The author is long UVXY. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Estimating Worst Case SWRs For Modern Portfolios

One of the challenges in dealing with modern portfolios like the Permanent Portfolio, the various IVY portfolios, Risk Parity portfolios, etc is the lack of long term historical data. Most of the modern portfolio data for a broad range of asset classes only goes back to 1973. The period from 1973 onward obviously only represents a subset of historical economic and financial conditions. This represents quite a challenge when looking forward and trying to model probable future outcomes for different portfolios. In the context of retirement this fact makes determining SWRs for modern portfolios difficult. The worst case historical 30 year retirement period that determines the SWR for the 60/40 US stock US bond portfolio began in 1966 . Fortunately, 1966 is not that far from 1973 which gave me an idea for estimating SWRs for modern portfolios as if they existed from 1966. Just use the 60/40 return data to for the modern portfolios from 1966 to 1972, then the modern portfolio return data going forward to estimate an SWR for these portfolios. This should give a conservative estimate for historical SWRs form these portfolios which is an apples to apples comparison to the SWR from the classic 60/40 portfolio, aka the famous 4% rule. Let’s see where this process takes us. In previous posts I had presented a variety of statistics for modern portfolios; returns, standard deviations, and SWRs. I also pointed out that the SWRs from these calculations had to be taken with a huge grain of salt. The retirement periods from 1973 onward, when the data for the modern portfolios begins, do not encompass the worst case period in history to retire, the 30 year period starting in 1966. The SWRs for periods starting in 1973 would be significantly higher than for those starting in 1966. In order to get an estimate of what SWRs for modern portfolios would have been going back to 1966 I simply took the historical return series for each of the modern portfolios and used the return data from the 60/40 portfolio from 1966 to 1972 for each portfolio. This will yield a conservative estimate of the modern portfolio SWRs going back to 1996. The assumption here of course is that the modern portfolios would have performed better than the 60/40 portfolios from 1966 to 1972. I think that’s a pretty safe assumption. Below is a table of the results along with the other portfolios stats that I updated through 2014. I did not do this exercise for all the portfolios I track just the ones I discuss the most often on the blog. First, all the portfolio stats in the table are for the period from 1973 to 2014, the actual performance of the portfolios. It is only for estimating the SWRs that I inserted the 1966 to 1972 60/40 return data. I labeled that line 1966 SWRs to make that distinction. As the 1966 SWR line shows, even with the initial 7 year (1966 to 1972) equal performance to the 6o/40 portfolio all of modern portfolios have significantly higher SWRs than the classic 60/40 or even 70/30 US stock US bond buy and hold portfolio. The more broadly diversified buy and hold portfolios, IVY B&H 5, IBY B&H 13, and the Permanent Portfolios have estimated 1966 SWRs ranging from 5.06% to 5.76%. The portfolios that add simple downside risk management (via the 10 month SMA) – the GTAA5 and GTAA 13 portfolios have 1966 SWRs of 5.36% and 6.13% respectively. GTAA 13 also adds value and momentum factors to the mix. Then the portfolios that have diversification, downside risk management, value and dual momentum factors have the highest 1966 SWRs of all. The Antonacci dual momentum portfolios, GEM and GBM, have 1966 SWRs of 5.71% and 5.68%. The aggressive IVY momentum portfolios, AGG6 and AGG3 lead the bunch with SWRs of 7.95% and 8.63% respectively. Pretty impressive all the way around even after handicapping the modern portfolios with 60/40 returns from 1966 to 1972. In summary, modern portfolios have significantly higher SWRs than the classic 4% SWR rule suggests. Even in the forecasted poor return scenarios that I’ve discussed before these portfolios will most likely perform much better than the classic portfolio that the original 4% SWR was based on. Does that mean that these estimated historical SWRs can be used for investors starting to withdraw from portfolios today? Possibly but I wouldn’t go so far as that. As the infamous disclaimer goes, past returns are no guarantee of the future. All we can do is put the odds in our favor. Being the conservative sort, I base my investment allocations on one or more of these modern portfolios but still stick the 4% SWR rule. Then I adjust SWRs accordingly maybe every 3-5 years. Regardless, the superior nature of the modern portfolios, not just in terms of SWRs, should be considered by all investors. Note: There is a lot of information about modern portfolios to glean from all of the portfolio stats in the above table for investors withdrawing from portfolios and even of investors still in the wealth building phase. Just look at the differences in returns/risk and long term wealth for these modern portfolios vs the most often recommended 60/40 buy and hold portfolio. The fact that the 60/40 portfolio is still the most common allocation for US investors is kind of crazy when you see these results.

Have Bonds Lost Their Safe Haven Status To Gold?

Summary Price correlations have changed. Bonds no longer trade inversely to stocks. Bonds are no longer the safe haven. Gold is the new market safe haven. Traditionally speaking, bonds and stocks have traded inversely to each other . This is evident if one looks at these charts below. In 2008, the TLT (a bond ETF) went up in value, whereas the Dow crashed. In 2009, the TLT declined in value, whereas the Dow began its new bull market. But in 2011, that traditional correlation changed. In 2011, the bond market started to rise in correlation with the stock market. The bond market didn’t rise in an esclator like fashion such as the stock market, but it did rise in correlation with the stock market. This new correlation can be attributed to foreigners buying US assets , combined with the fact that the Federal Reserve was buying US treasuries, thus suppressing interest rates. Foreigners weren’t just buying US stocks, they have also bought US real estate as well . This form of flight capital and QE, has now made all US assets rise contemporaneously. In 2011, this wasn’t the only correlation that changed, as the two charts below show. As you can see from 2005-07, the price of gold rose in correlation with the stock market. Then in 2008, during the financial crisis, the price of gold declined with the stock market. From 2009-2011, Gold and the Dow, both rose in value. In 2011, however, that correlation changed. Gold started to decline in value, while the stock market keep rising. In my opinion, the one correlation that hasn’t changed, is the one between gold and bonds. Looking at the two charts below, I think they have always traded inversely of each other. From 2005 to 2007, gold rose in value, while the bond market remained relatively flat. During the ’08 crisis, bonds rose almost vertically, while the price of gold declined briefly. After the 08 crisis, the price of gold rose drastically, while the bond market declined. Lastly, in 2011, the bond market started to rise in value, while gold started its decline. Conclusion As stated above, one can see the price correlations have changed, this is likely due to global quantitative easing . If there is another crash, or foreigners loose confidence in the US markets, stocks and bonds will have a high a probability of declining in value at the same time, and unlike previous market panics, gold will be the new safe haven, and not bonds. I am not saying there will be a market crash soon, but if there is, it won’t be bonds that will perform well (like they did in 2008), it will be gold. Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.