The Time To Hedge Is Now – August 2015 Update
Summary Brief overview of the series. The most ominous potential trigger events. One new candidate to consider. Current buy prices on my top ten preferred hedge candidates. Discussion of the risks inherent to this strategy versus not being hedged. Back to June 2015 Update Strategy Overview The May highs on the S&P 500 Index have held so far. Will that be it? Hard to say. But there are some potential catalysts to throw the economy and financial markets into disarray. I will explain those in a few moments. Readers regularly offer up possible candidates to me, but somehow there is usually something missing and most do not meet my criteria. One reader (who prefers to remain mysteriously anonymous) offered up a list of companies that he thought should be considered. After taking a hard look at his abundant analysis, I found two that I believe should be considered. I will explain how he selected them and detail my thoughts on one for immediate consideration (I am adding a position myself) later in this article. If you are new to this series, you will likely find it useful to refer back to the original articles, all of which are listed with links in this instablog . In the Part I of this series, I provided an overview of a strategy to protect an equity portfolio from heavy losses in a market crash. In Part II, I provided more explanation of how the strategy works and gave the first two candidate companies to choose from as part of a diversified basket using put option contracts. I also provided an explanation of the candidate selection process and an example of how it can help grow both capital and income over the long term. Part III provided a basic tutorial on options. Part IV explained my process for selecting options and Part V explained why I do not use ETFs for hedging. Parts VI through IX primarily provide additional candidates for use in the strategy. Part X explains my rules that guide my exit strategy. All of the above articles include varying views that I consider to be worthy of contemplation regarding possible triggers that could lead to another sizeable market correction. Part II of the December 2014 update explains how I have rolled my positions. I want to make it very clear that I am NOT predicting a market crash. I just like being more cautious at these lofty levels. Bear markets are a part of investing in equities, plain and simple. I like to take some of the pain out of the downside to make it easier to stick to my investing plan: select superior companies that have sustainable advantages, consistently rising dividends and excellent long-term growth prospects. Then, I like to hold onto to those investments unless the fundamental reasons for which I bought them in the first place changes. Investing long term works. I just want to reduce the occasional pain inflicted by bear markets. If the market (and your portfolio) drops by 50 percent, you will need to double your assets from the new lower level just to get back to even. I prefer to avoid such pain. If the market drops by 50 percent and I only lose 20 percent (but keep collecting my dividends all the while), I only need a gain of 25 percent to get back to even. That is much easier than a double. Trust me, I have done it both ways and losing less puts me way ahead of the crowd when the dust settles. I may need a little lead to keep up because I refrain from taking on as much risk as most investors do, but avoiding huge losses and patience are the two main keys to long-term successful investing. If you are not investing long term, you are trading. And if you are trading, your investing activities, in my humble opinion, are more akin to gambling. I know. That is what I did when I was young. Once I got that urge out of my system, I have done much better. I have fewer huge gains, but had I also have eliminated the big losses. It makes a really big difference in the end. A note specifically to those who still think that I am trying to “time the market” or who believe that I am throwing money away with this strategy. I am perfectly comfortable to keep spending 1.5 percent of my portfolio per year for five years, if that is what it takes. Over that five-year period, I will have paid a total insurance premium of as much as 7.5 percent of my portfolio (approximately 1.5 percent per year average, although my true average is less than one percent). If it takes five years beyond the point at which I began, so be it. The concept of insuring my exposure to risk is not a new concept. If I have to spend 7.5 percent over five years in order to avoid a loss of 30 percent or more, I am perfectly comfortable with that. I view insurance, like hedging, as a necessary evil to avoid significant financial setbacks. From my point of view, those who do not hedge are trying to time the market. They intend to sell when the market turns but always buy the dips. While buying the dips is a sound strategy, it does not work well when the “dip” evolves into a full-blown bear market. At that point the eternal bull finds himself catching the proverbial rain of falling knives as his/her portfolio tanks. Then panic sets in and the typical investor sells after they have already lost 25 percent or more of the value of their portfolio. This is one of the primary reasons why the typical retail investor underperforms the index. He/she is always trying to time the market. I, too, buy quality stocks on the dips, but I hold for the long term and hedge against disaster with my inexpensive hedging strategy. I do not pretend that mine is the only hedging strategy that will work, but offer it up as one way to take some of the worry out of investing. If you do not choose to use my strategy that is fine, but please find a system to protect your holdings that you like and deploy it soon. I hope that this explanation helps clarify the difference between timing the market and a long-term, buy-and-hold position with a hedging strategy appropriately used only at the high end of a near-record bull market. The Most Ominous Potential Trigger Events The Chinese situation is still one of the two potential trigger events that worry me the most. But right now there is one more that concerns me even more. I will get to that in a moment. The Chinese leadership has taken unprecedented steps to “manage” its equities markets. This link to CNN Money outlines the first ten steps taken by China to support the Shanghai and Shenzhen equity markets. Unfortunately, these moves were not enough. The markets did respond to some of the actions by rebounding for one or two days in each case, but then continued to slide. The accompanying video (< four minutes) contains some valuable insights about the challenges faced by Chinese authorities in the coming months. The most recent move by China was to infuse its China Securities Finance corporation, a government agency that invests in whatever the government need to prop up and often referred to as the CSF, with additional buying power of nearly $1 trillion (including potential leverage) to buy equities. That has kept shares from falling further, but has not changed perception yet. So Chinese stocks remain more than 30 percent off highs set in June this year. There are still over a thousand company stocks on which trading has been halted. What is going through the minds of the investors who own those shares? For now, they are not losing money. But when the stocks begin trading again, having been halted well above current levels, there is a very good chance those shares will take a tumble. Another aspect is that, as an investor in equities, we often take comfort in knowing that at any time we can access our money by selling our shares in a liquid market. But when one is no longer able to sell shares, one cannot access the money. It is very similar to having money in a bank (think Greece) and not be able to make withdrawals. That makes investors nervous and can have a lasting effect on their respective perspectives. That could boil over into how investors begin to think about other investments. It is a good life lesson to learn, but have the Chinese investors learned from it? Only time will tell. I can't write too much about China here or this article will become too long, so I will just include a few more links here that should help you understand the situation better: Why The China Stock Crash Matters The dark side of China's heavy-handed response to its plunging stock markets China's stock market crash is a problem for the whole world Giant Hedge Fund Bridgewater Flips View on China: 'No Safe Places to Invest' The point of all this is that if China cannot prop up equities now while the real estate market is still soft, the potential negative psychological impact on Chinese investors could spill over into other areas of the economy, not just stocks. Only about 15 percent of household savings in China is invested in stocks, so if this can be managed, the overall impact could be contained. But if it cannot be managed and stocks fall further, the fear could spill over into real estate where about 70 percent of household wealth is invested. Then, the problem becomes panic and fear and leadership loses control. The result could be that the engine driving world economic growth crashes and where does that leave the rest of us? Now for the second, and more imminent problem we face, as if China is not big enough. The energy sector, especially oil prices, has not found a bottom yet. I recently wrote a three-article series which explains this in greater detail. But to summarize, as oil prices continue to fall due to oversupply while we near the end of driving season in the northern hemisphere and peak annual demand, more and more oil-producing companies in the U.S. are going to be required to write down assets (reserves) and will continue to lose money each quarter at least through year end. This will trigger loan covenants that will force companies into bankruptcies (the process is also explained in more detail in Part III of the series linked above). That, in turn, will raise red flags for holders of other junk bonds as interest rates rise due to the increase in bankruptcies. And it gets worse because many junk-rated bonds in emerging markets are denominated in U.S. dollars and will get hit hard similar to what we saw when our Fed decided to exit its QE strategy. The result before, even without a crash in junk bonds was a global economic slowdown due to stricter borrowing requirements. That led to significant equity devaluation in many emerging market exchanges. I believe it will again this time. And the junk bond market today is much larger than the $800 billion problem we faced with Lehman Brothers. Now, it may be that our Fed and political leaders decide to put us all further into debt in order to save us once again, but that will merely prolong the inevitable, in my opinion. The fact is I do not believe that the political will is there to step up big enough to contain this one. Again, I could be wrong in how I have assessed this risk, but it is certainly a major concern and we should tread cautiously until early next year when I believe the worst (relating to the energy sector) will be behind us. The current bull is now longer in duration than all is getting very long in the tooth. So, I am preparing for the inevitable next bear market. I do not know when the strategy will pay off, and I will be the first to admit that I am probably earlier than I suggested at the beginning of this series. However, I do feel confident that the probability of experiencing another major bear market will rise in the coming year(s). It may be 2015, 2016 or even 2017, before we take another hit like we did in 2000-2002 or 2008-09. But I am not willing to risk watching as much as 50 percent of my portfolio evaporate to save the average of about one percent per year cost of a rolling insurance hedge. I am convinced that the longer the duration of the bull market lasts, the worse the resulting bear market will be. I continue to base my expected hedge position returns on a market swoon of 30 percent, but now believe that the slide could be much worse as this bull continues to outlive its ancestry. You may disagree with my assessment of the potential severity of the next recession and the impact it will wreak on equities; none of us knows with certainty what the outcome will be or when it will happen. It is very conceivable that we could experience a mild correction, followed by a strong bounce, before the really big bad bear shows itself. But there is one thing we all do know: eventually it will come. I will be prepared. Will you? New Candidate to Consider I want to introduce the Men's Wearhouse (NYSE: MW ) as a new candidate. It has all the attributes of a potential big loser in the next recession: a beta of 1.66, it is losing money because of a recent large merger and has taken on a lot of debt, and it fell faster and further (80 percent) than the overall market in 2008-09. The company operates in the retail clothing industry, where sales generally drop dramatically when people lose or worry about losing jobs. A men's suit purchase can often be put off for a year or two for most middle-class households. And, based upon the additional analysis by my new friend, the stock fell 30 percent in 2011 when the broad market fell 19.4 percent, and it fell about 24 percent in 2014 when the broader market was down only 7.4 percent. I like those odds. Might I also point out that learning from one another and trading ideas and analysis is one of the great benefits of Seeking Alpha. I may not have identified this candidate without help from a complete stranger a thousand miles away. I will include the specifics on MW below in the list my top of candidates. Current Premiums on Select Candidates In this section, I will provide current quotes and other data points on selected candidates that pose an improved entry point from the last update. All option quotes are based upon the close on Monday, August 4, 2015. The stock quotes are all from during the market after lunch on Tuesday. I am writing the finishing touches on this article on Tuesday, but since the market and all but one of my candidates' stock prices are up, I decided not to take the several hours it takes to update the selection process of my put candidates. You should be able to get better entry points than those listed below. I am calculating the possible gain percentage, total estimated dollar amount of hedge protection (Tot Est. $ Hedge) and the percent cost of portfolio using the "ask" premium. You should be able to do better than the listed premium unless the share price of the listed stock has fallen significantly between Monday (only MAR is down) and the time you read this article. I suggest that, if you decide to buy puts to employ this strategy, you should place limit orders only at about the midpoint between the most recent bid and ask prices listed. You may need to adjust your bid slightly higher if you do not get a fill, but a few pennies does not ruin the return potential on the listed option contracts. I try to buy on days when the market is either making new highs or nearing those levels and on a day when the market in general is heading higher. Please remember that all calculations of the percent cost of portfolio are based upon a $100,000 equity portfolio. If you have an equity portfolio of $400,000, you will need to increase the number of contracts by a factor of four to gain adequate coverage. Also, the hedge amount provided is predicated upon a 30 percent drop in equities during an economic recession and owning eight hedge positions that provide protection that approximates $30,000 for each $100,000 of equities. So, you should pick eight candidates from the list and make sure that the hedge amounts total to about $30,000 (for each $100,000 value in your stock portfolio). Since each option represents 100 shares of the underlying stock, we cannot be extremely precise, but we can get very close. If the market drops by more than 30 percent, I expect that to do better than merely protect my portfolio because these stocks are very likely to fall further and faster than the overall market, especially in a crash. Another precaution: do not try to use this hedge strategy for the fixed income portion of your portfolio. If the total value of your portfolio is $400,000, but $100,000 of that is in bonds or preferred stocks, use this strategy to hedge against the remaining $300,000 of stocks held in the portfolio (assuming that stock is all that is left). This is also not meant to hedge against other assets such as real estate, collectibles or precious metals. Finally, the companies are not listed in the order of my preference, but represent my favorite ten at this time. If you want a more detailed explanation of why I expect these particular stocks to fall more than the broad market, please refer to the earlier articles in this series which can be found at this link . To keep the overall length of this article down, I will dispense with my reasoning for each candidate as that can be found detailed at the link. If you disagree with my expectations for any of the stocks listed, please feel free to mix and match or use some others with which you feel more comfortable. Just make sure that the stocks you use are likely to be ravaged more by a recession than the average company. Goodyear Tire & Rubber (NASDAQ: GT ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $31.04 $8.00 $22.00 $0.20 $0.30 4,567 $4,110 0.09% I would need three January 2016 GT put option contracts to cover approximately one-eighth of a $100,000 equity portfolio. If you already own a full position of GT options, do not exchange those for the new position. This would only add to your cost by increasing transactions. This new position is for anyone who has not yet completed their position or who may be rolling over to replace a July position. This statement applies to all of the "new" positions listed in this article. Do not trade in and out of positions to try to improve your overall position. That just defeats the purpose of keeping this strategy affordable. A better strategy is to average into a position over time, lowering your average cost basis with each purchase. Williams-Sonoma (NYSE: WSM ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $85.96 $24.00 $72.50 $1.55 $1.80 2,594 $4,670 0.180% I need only one January 2016 WSM put option contract to provide the indicated loss coverage for each $100,000 in portfolio value. Tempur Sealy International (NYSE: TPX ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $76.54 $16.00 $60.00 $1.05 $1.50 2,567 $3,850 0.150% I will need only one January 2016 TPX put options to complete this position for each $100,000 in portfolio value. Royal Caribbean Cruises (NYSE: RCL ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $90.01 $22.00 $72.50 $1.57 $1.65 2,961 $4,885 0.165% I need one January 2016 RCL put option contract to provide the indicated loss coverage for each $100,000 in portfolio value. Men's Wearhouse Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $58.49 $25.00 $45.00 $0.55 $0.75 2,567 $3,850 0.150% I need two January 2016 MW put options to provide the indicated loss coverage for each $100,000 in portfolio value. Marriott International (NASDAQ: MAR ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $70.80 $30.00 $62.50 $1.30 $1.45 2,141 $3,105 0.145% I need one January 2016 MAR put option contract to provide the indicated loss coverage for each $100,000 in portfolio value. E*TRADE Financial (NASDAQ: ETFC ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $29.28 $7.00 $22.00 $0.32 $0.43 3,388 $4,371 0.129% The position shown above would require three January 2016 ETFC put option contracts to provide the indicated loss coverage for each $100,000 in portfolio value. Morgan Stanley (NYSE: MS ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $38.98 $15.00 $35.00 $0.91 $0.96 1,983 $3,808 0.192% I need two January 2016 MS put contracts to provide the indicated loss coverage for each $100,000 in portfolio value. L Brands (NYSE: LB ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $84.49 $24.00 $70.50 $1.40 $1.50 2,600 $3,900 0.150% I need one January 2016 LB put contract to provide the indicated loss coverage for each $100,000 in portfolio value. Sotheby's (NYSE: BID ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $41.95 $16.00 $31.00 $0.25 $0.55 2,627 $4,335 0.165% I need three January 2016 BID put contracts to provide the indicated loss coverage for each $100,000 in portfolio value. Summary My top eight choices at this time, in the order of my preference, are LB, MAR, WSM, RCL, MS, GT, ETFC, TPX, BID and MW. Using the first eight, the group (using the put option contracts suggested above) should provide approximately $32,699 in downside protection against a 30 percent market correction at a cost of 1.2 percent of a $100,000 portfolio. Overall, my average cost to hedge this year is less than to 1.5 percent of my equity portfolio. If you want to employ this strategy but do not like using one or more of these eight candidates for a hedge position, please feel free to choose from the other eight or pick some of your own. Brief Discussion of Risks If an investor decides to employ this hedge strategy, each individual needs to do some additional due diligence to identify which candidates they wish to use and which contracts are best suited for their respective risk tolerance. I do not always choose the option contract with the highest possible gain or the lowest cost. I should also point out that in many cases I will own several different contracts with different strikes on one company. I do so because as the strike rises, the hedge kicks in sooner, but I buy a mix to keep the overall cost down. My goal is to commit approximately two percent (but up to three percent, if necessary) of my portfolio value to this hedge per year. If we need to roll positions before expiration there will be additional costs involved, so I try to hold down costs for each round that is necessary. I do not expect to need to roll positions more than once, if that, before we see the benefit of this strategy work. I want to discuss risks for a moment now. Obviously, if the market continues higher beyond January 2016, all of our new option contracts could expire worthless. I have never found insurance offered for free. We could lose all of our initial premiums paid plus commissions. If I expected that to happen, I would not be using the strategy myself. But it is one of the potential outcomes and readers should be aware of it. And if that happens, I will initiate another round of put options for expiration beyond January 2016, using from up to three percent of my portfolio to hedge for another year. The longer the bull maintains control of the market, the more the insurance will cost me. But I will not be worrying about the next crash. Peace of mind has a cost. I just like to keep it as low as possible. Because of the uncertainty in terms of how much longer this bull market can be sustained and the potential risk versus reward potential of hedging versus not hedging, it is my preference to risk a small percentage of my principal (perhaps as much as three percent per year) to insure against losing a much larger portion of my capital (30 to 50 percent). But this is a decision that each investor needs to make for themselves. I do not commit more than five percent of my portfolio value to an initial hedge strategy position and have never committed more than ten percent to such a strategy in total before a major market downturn has occurred. The ten percent rule may come into play when a bull market continues much longer than expected (like three years instead of 18 months). And when the bull continues for longer than is supported by the fundamentals, the bear that follows is usually deeper than it otherwise would have been. In other words, I expect a much less powerful bear market if one begins early in 2015; but if the bull can sustain itself into late 2015 or beyond, I would expect the next bear market to be more like the last two. If I am right, protecting a portfolio becomes ever more important as the bull market continues. As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other's experience and knowledge. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More...) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: I own put option positions in all the stocks listed as part of my personal portfolio hedge strategy.
