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Investing While Guarding Against Extensive Vertical Losses

Summary Portfolio Manager and economist John Hussman warns that “extensive vertical losses” can follow a partial recovery from a correction similar to our recent one. One way to remain invested while guarding against extensive vertical losses is with the hedged portfolio method, which we outline here. We also present an example of a hedged portfolio designed for an investor with $200,000 who is unwilling to risk losses greater than 20%. Hussman Says We’re Due On Twitter (NYSE: TWTR ) earlier this month, the pseudonymous Florida-based trader StockCats shared the following chart, first posted a year earlier: The next day, the creator of the image, portfolio manager, Stanford Ph.D., and former finance professor John Hussman responded: In his next weekly market commentary (“That was not a crash”), Hussman updated his bearish sentiment: The market decline of recent weeks was not a crash. It was merely an air-pocket. It was probably just a start. Actual market crashes involve a much larger and concerted shift toward investor risk-aversion, which doesn’t really happen right off of a market peak. Historically, market crashes don’t even start until the market has first retreated by 10-14%, and then recovers about half of that loss, offering investors hope that things have stabilized (look for example at the 1929 and 1987 instances). The extensive vertical losses that characterize a crash follow only after the market breaks that apparent “support,” leading to a relentless free-fall that inflicts several times the loss that we’ve seen in recent weeks. If you were certain Hussman was right that the recent correction has just been an “air pocket,” and we’re due for worse, then an appropriate course of action might be to get out of the market. But as strong a case as Hussman makes, he’s been making a similar one for years. And even he doesn’t go so far as to predict exactly when he expects we’ll get the crash we’re due to get. So we’re left with the question of how to invest given the uncertainty of whether the long bull market will resume or we’ll soon be faced with Hussman’s ominous “extensive vertical losses.” Dealing With Uncertainty One way to deal with this sort of uncertainty is to invest in a handful of securities you think will do well, and hedge against the possibility that you end up being wrong. That approach is systematized in the hedged portfolio method, which we detailed in a previous post (“Backtesting The Hedged Portfolio Method”). One advantage of the hedged portfolio method is that it can accommodate a broad range of risk tolerances. Below, we’ll recap how you can build a hedged portfolio yourself (or for a client), and present an example of a hedged portfolio created for an investor with $200,000 to invest who can’t tolerate a drawdown of more than 20%. Risk Tolerance, Hedging Cost, And Potential Return All else equal, with a hedged portfolio, the greater an investor’s risk tolerance – the greater the maximum drawdown he is willing to risk (his “threshold”) – the lower his hedging cost will be and the higher his expected return will be. An investor who is willing to risk a 20% drawdown is in good company. Several years ago, in one of his earlier market commentaries , portfolio manager John Hussman had this to say about 20% drawdowns: “An intolerable loss, in my view, is one that requires a heroic recovery simply to break even… a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally).” Essentially, 20% is a large enough threshold that it can reduce the cost of hedging, but not so large that it precludes a recovery. Constructing A Hedged Portfolio The process, in broad strokes, is this: Find securities with high potential returns (we define potential return as a high-end, bullish estimate of how the security will perform). Find securities that are relatively inexpensive to hedge. Buy a handful of securities that score well on the first two criteria; in other words, buy a handful of securities with high potential returns net of their hedging costs (or, ones with high net potential returns). Note that when creating a hedged portfolio for an extremely risk-averse investor, such as in this case, the second criteria (“inexpensive to hedge”) will outweigh the first (“high potential returns”) because it may not be possible to hedge the securities with the highest potential returns against such small declines. Hedge them. The potential benefits of this approach are twofold: If you are successful at the first step (finding securities with high potential returns), and you hold a concentrated portfolio of them, your portfolios should generate decent returns over time. If you are hedged, and your return estimates are completely wrong, on occasion – or the market moves against you – your downside will be strictly limited. How To Implement This Approach Finding securities with positive potential returns For this, you can use Seeking Alpha Pro , among other sources. Seeking Alpha articles often include price targets for long ideas, and you can convert these to percentage returns from current prices. But you’ll need to use the same time frame for each of your expected return calculations to facilitate comparisons of expected returns, hedging costs, and net expected returns. Our method starts with calculations of six-month potential returns. Finding Securities That Are Relatively Inexpensive To Hedge For this step, you’ll need to find hedges for the securities with positive potential returns, and then calculate the hedging cost as a percentage of position value for each security. Whatever hedging method you use, for this example, you’d want to make sure that each security is hedged against a greater than 4% decline over the time frame covered by your potential return calculations. Our method attempts to find optimal static hedges using collars as well as protective puts. Buying Securities That Score Well On The First Two Criteria To determine which securities these are, you may need to first adjust your potential return calculations by the time frame of your hedges. For example, although our method initially calculates six-month potential returns and aims to find hedges with six months to expiration, in some cases the closest hedge expiration may be five months out. In those cases, we will adjust our potential return calculation down accordingly, because we expect an investor will exit the position shortly before the hedge expires (in general, our method and calculations are based on the assumption that an investor will hold his shares for six months, until shortly before their hedges expire or until they are called away, whichever comes first). Next, you’ll need to subtract the hedging costs you calculated in the previous step from the potential returns you calculated for each position, and sort the securities by their potential returns net of hedging costs, or net potential returns. The securities that come to the top of that sort are the ones you’ll want to consider for your portfolio. Fine-Tuning Portfolio Construction You’ll want to stick with round lots (numbers of shares divisible by 100) to minimize hedging costs. Another fine-tuning step is to minimize cash that’s left over after you make your initial allocation to round lots of securities and their respective hedges. Because each security is hedged, you won’t need a large cash position to reduce risk. And since returns on cash are so low now, by minimizing cash, you can potentially boost returns. In this step, our method searches for what we call a “cash substitute”: that’s a security collared with a tight cap (1% or the current yield on a leading money market fund, whichever is higher) in an attempt to capture a better than cash return while keeping the investor’s downside limited according to his specifications. You could use a similar approach, or you could simply allocate leftover cash to one of the securities you selected in the previous step. Calculating An Expected Return While net potential returns are bullish estimates of how well securities will perform, net of their hedging costs, expected returns, in our terminology, are the more likely returns net of hedging costs. In a series of 25,412 backtests over an 11-year time period, we determined two things about our method of calculating potential returns: it generates alpha, and it overstates actual returns. The average actual return over the next six months in those 25,412 tests was 0.3x the average potential return calculated ahead of time. So, we use that empirically derived relationship to calculate our expected returns. Example Of A Hedged Portfolio Here is an example of a hedged portfolio created using the general process described above by the automated portfolio construction tool at Portfolio Armor . With that tool, you just enter the dollar amount you are looking to invest (in this case, $200,000) and the largest drawdown you are willing to risk (your “threshold” – in this case, 20%), as in the image below, and the tool does the rest. Note that we left the “tickers” field blank above, because, in this case, we’re going to let the site pick all of the securities for us. But you can also start with your own investment picks when using this tool. We shared an example of that in a recent article (“Building a Bulletproof Stock Portfolio”). A couple of minutes after clicking the “create” button above, we were presented with the portfolio below, which was generated with data as of Friday’s close. Worst-Case Scenario The “Max Drawdown” column in the portfolio level summary shows the worst-case scenario for this hedged portfolio. If every underlying security in it went to zero before the hedges expired, the portfolio would decline 18.92%. Negative Hedging Cost Note that, in this case, the total hedging cost for the portfolio was slightly negative, -0.01%, meaning the investor would receive a few dollars more income in total from selling the call legs of the collars on his positions than he spent buying the puts. Best-Case Scenario At the portfolio level, the net potential return is 15.16%. This represents the best-case scenario, if each underlying security in the portfolio meets or exceeds its potential return. A More Likely Scenario The portfolio level expected return of 6.10% represents a more conservative estimate, based on the historical relationship between our calculated potential returns and actual returns. Each Security Is Hedged Note that in the portfolio above, each of the four primary underlying securities – Abiomed (NASDAQ: ABMD ), BofI Holding (NASDAQ: BOFI ), Expedia, Inc. (NASDAQ: EXPE ), and Sketchers, USA (NYSE: SKX ) – is hedged with an optimal collar capped at its potential return, and Amazon (NASDAQ: AMZN ) is hedged as a cash substitute, with its cap set at 1%. Hedging each security according to the investor’s risk tolerance obviates the need for broad diversification, and lets him concentrate his assets in a handful of securities with high net potential returns. Here’s a closer look at the hedge for one of these positions, ABMD: As you can see in the first part of the image above, ABMD is hedged with an optimal collar with its cap set at 21.92%, which was the potential return Portfolio Armor calculated for the stock: the idea is to capture the potential return while offsetting the cost of hedging by selling other investors the right to buy ABMD if it appreciates beyond that over the next six months. The cost of the put leg of this collar was $3,600, or 9.42% of position value, but as you can see in the image below, the income from the short call leg was $2,600, or 6.80% as a percentage of position value. Since the income from the call leg offset some of the cost of the put leg, the net cost of the optimal collar on ABMD was $1,000, or 2.62% of position value.[i] Note that, although the cost of the hedge on this position was positive, the hedging cost of this portfolio as a whole was slightly negative . Why These Particular Securities? As of Friday, all of these securities ranked among the top six names in the site’s universe when ranked by potential return net of hedging costs. Possibly More Protection Than Promised In some cases, hedges such as the ones in the portfolio above can provide more protection than promised. For an example of that, see this instablog post on hedging the iPath S&P 500 VIX ST Futures ETN (NYSEARCA: VXX ). Hedged Portfolios For Even More Risk-Averse Investors The hedged portfolio shown above was designed for a small investor who could tolerate a decline of as much as 20% over the next six months, but the same process can be used for investors who are more risk averse. We presented an example of that in a recent article (“An Alternative To Cash For Risk-Averse Investors”). Note: [i] To be conservative, the net cost of the collar was calculated using the bid price of the calls and the ask price of the puts. In practice, an investor can often sell the calls for a higher price (some price between the bid and ask) and he can often buy the puts for less than the ask price (again, at some price between the bid and ask). So, in practice, the cost of this collar would likely have been lower. 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.

Stable Belgium Can Give A Decent Profit

Summary EWK, an ETF based on Belgian shares, has significant relative strength. There are no serious threats to the Belgian economy. Government crisis and bankruptcies in the banking sector are in the distant past. The iShares MSCI Belgium Capped ETF (NYSEARCA: EWK ), based on the shares of Belgian companies, ranks extremely high in the ETF World Matrix with Cash list, edited by investment company Dorsey Wright. To gauge whether this extremely interesting ETF’s ranking is justified, it’s worth looking at what exactly the situation in the Belgium economy is like. First, we should explain how the ranking is done. Dorsey Wright compares selected ETFs with each other (one each for each). There are 34 ETFs that are ranked. The main factor is relative strength of each fund. Relative strength tells us how much the price of the company (or of the fund) grows in comparison to other companies (funds). The relative strength indicator, in conjunction with fundamental analysis is quite effective. Why? On the stock exchange, there is a principle of inertia: a company (or fund) that is growing strongly is hard to stop. Below, you can see top of the World ETF Matrix with Cash ranking order. EWK is in third position. The Guggenheim S&P 500 Equal Weight ETF (NYSEARCA: RSP ) is ranked first and the iShares Dow Jones U.S. ETF (NYSEARCA: IYY ) is second. (click to enlarge) Source: Dorsey Wright So, let’s take a glance at the fundamental situation in Belgium. The Political Situation The political situation in Belgium is now stable. Charles Michel has been at the helm of the government since 11th October, 2014. The Kingdom of Belgium is a federal parliamentary democracy under a constitutional monarchy. It is divided into 3 regions: Brussels – the Capital Region, the Flemish Region and the Walloon Region. Since 1993, there are three levels of government (federal, regional, and linguistic community). In 2012, the sixth state reform transferred additional competencies from the federal state to the regions and linguistic communities. It is worth recalling that a few years ago, Belgium was without a viable government due to a political deadlock between the Flemish and Walloons . This political crisis had paralyzed the country’s political apparatus from June 2010 till December 2011 (for 589 days, Belgium was without a federal government). In this period, the 20 biggest companies index, BEL20, went down 23%, and the 10-year bond yield went up from 3,097 to 5,910 (91%). Euronext Brussels BEL20 Index (BEL20) vs. BELGIUM 10-Year Bond Yield (10BEY.B) Source: Stooq The European Parliament is based in Brussels. For this reason, the city is often witness to protests. Economy and Finances Belgium is a small but highly urbanized and industrialized country. Poor in natural resources, it imports raw materials in great quantity and processes them largely for export. Exports account for around two-thirds of Belgium’s GDP. Almost 75% of its foreign trade is with other European Union countries, so the country is highly exposed to business tendencies in the EU. Belgium is the world’s most congested country, with drivers losing 51 hours a year , on average, to traffic jams (in Brussels, 74 hours). The cost of traffic jams in Belgium is 10.58 euros per hour , according to Leuven transport researcher Sven Maerivoet. Efficient mobility is a big problem for society of Belgium, and traffic jams are causing real harm to the economy. From Q2 2013, Belgium’s GDP growth rate is stable, but rather poor (0-0.5%). In Q2 2015, the country’s economy expanded 0.4% over the previous quarter. The indicator almost perfectly reproduces what is happening in the EU economy (please look at the chart below). The unemployment rate is projected to decrease from a ten-year high of 8.5% last year to 8.1% in 2016 as job creation in the private sector picks up – according to European Commission data. We can name it a “slow-moving recovery”. GDP growth rate: Belgium vs. the EU (click to enlarge) Source: Trading Economics What are the weaknesses of Belgium’ economy according to the European Commission’s “Country Report Belgium 2015” ? Chronic underutilisation of labour, with a low aggregate employment rate A high overall tax burden Competition in several key service sectors remains low One of the most interesting facts about Belgium’s labour market is presented at the chart below. Labour costs in the country are indirectly linked to productivity developments. Productivity and Wage Evolution (2009 = 100) It is no wonder that Belgium falls lower and lower on the index of economic freedom. Belgium – Index of Economic Freedom in 2015, Score: 68.8 (100 represents the maximum freedom) Source: Knoema What is worrying is that the country’s ability to make future payments on its debt is decreasing. Government debt as a percent of GDP (106.50% in 2014) is skyrocketing from 2008 and is higher than the EU average (92%). But what’s interesting is, it’s still below Belgium’s average level from years 1980-2014 (108.96%). Government Debt-to-GDP: Belgium vs. the EU (click to enlarge) Source: Trading Economics Public finances in Belgium are in a condition that is characteristic of those in almost all EU countries: poor, but stable. The country can only dream of having a budgetary surplus. (click to enlarge) We need to put a question mark on the 2015 budget. The Federal state budget deficit plan for 2015 was 8.50 bln EUR . As the end of July, it was 8.33 bln EUR. Yes, the budget deficit is seasonal (tax revenues are notably higher in the second half of the year than in the first half), but it seems that the first half of the year was a bit too wasteful. We should remember also that foreign investors own a majority of Belgium’s treasury certificates and linear bonds. This dependence makes the country very susceptible to a loss of market confidence. And what about ratings? Fitch Ratings : Rating AA affirmed, outlook negative (24/07/2015) S&P : Rating AA affirmed, outlook stable (17/07/2015) Moody’s : Rating Aa3 affirmed, outlook changed from negative to stable (07/03/2014) DBRS : Rating AA (high) confirmed, stable trend (13/03/2015) Japanese Credit Rating Agency : Rating AAA affirmed, outlook stable (01/07/2014) Rating and Investment Information, Inc . : Rating AA+ affirmed, outlook stable (31/08/2015) The Banking Sector In the years 2008-11, Belgium was struggling with a banking sector crisis, which revealed the incompetence of EU regulators and ratings agencies. In October 2011, the country nationalized big bank Dexia ( OTC:DXBGF ), which had passed stress tests year earlier. What’s the situation right now? KBC Bank ( OTCPK:KBCSF ) has repaid 7 bln EUR of federal loans, and it’s in good condition. Dexia is not an active bank. Fortis was rebranded as Ageas ( OTC:AGESF ), and is now an insurer (without toxic assets). What is interesting is that in the next three years, a great consolidation is expected in the Belgian banking sector – according to Ernst & Young’s “European Banking Barometer – 2015” presentation . According to the same report, Belgian bankers expect stabilization in the economy and in the banking market. The Real Estate Market If we look at the chart below, the bubble appears to be growing… (click to enlarge) … but property price levels remain moderate compared to those in other EU member states. Average price/m² of a 120 m² apartment located in the capital (in EUR) (BE – Belgium) Source: Global Property Guide Remember, of course, that in the charts above, we see the effects of extreme easing of monetary conditions in EU. Summary The political situation in Belgium is stable. The economy is in a slow recovery. Federal state finances are not in good shape, but where are they so (speaking about the EU)? The banking sector is recovering. Belgium does not stand out like on the plus side, but there are no serious threats for this country either. The investment mood has been very good, despite China’s fundamental problems. In fact, there are a few good reasons to invest in European equities . For example, quantitative easing provides support to consumption and money supply in the eurozone. Result? Better growth. Those who are already invested in the European and Belgian markets could patiently wait for further developments. For investors who like medium amounts of risk, invest in ETFs with exposure to Belgium. How to invest in the country There are some ETFs with exposure to stocks listed in Belgium. EWK has the largest exposure. 5 ETFs with the largest exposure to Belgium (click to enlarge) Source: ETFdb.com And here we have the most economical solutions: 5 cheapest ETFs with exposure to Belgium (click to enlarge) Source: ETFdb.com You may ask: Where is EWK in this ranking? Well, it’s in the 11th position, with ER = 0.47%. Not so bad. 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.

The Big, Bad Floating NAV Is Coming Your Way

Summary Prime money market funds are going to be reporting their net asset values on a floating basis due to recent SEC rules. The effect will be to render these funds costlier, both on an accounting and a tax basis, and might lead to an outflow from these funds. However, the weighted average maturity of these funds, one measure of their riskiness, is well within SEC guidelines. The big, bad floating NAV is coming your way In 2014 the SEC adopted amendments to rules that govern certain types of money market funds. In particular prime money market funds – those that invest in corporate debt securities will have to report floating Net Asset Values (NAVs) instead of posting fixed NAVs as has hitherto been the case. Thus at any given time, capital appreciation or depreciation will have to be reported, leading to a move towards money market funds with a Treasury or municipal bond focus. Instead of assuming a fixed NAV of $1.00, investors will have to confirm the posted NAV price. There will also be liquidity management issues, since the use of these money market funds for intra-day liquidity management will be much diminished, given the uncertainties about the NAVs for these funds. Companies would have to monitor the marking-to-market value of these funds on their balance sheets. Finally, all sales of money market fund shares would become taxable events. Rule 2A-7 risk limiting provisions amended Traditionally SEC’s Rule 2A-7, adopted in 1983, allowed money market funds to use amortized cost to value the funds so long as they kept within very strict parameters. Since money market funds are not insured by the FDIC, they have traditionally had to keep within limits about the three primary risks they face. Of course, the first was interest risk, credit risk and liquidity risk (the risk that a borrower will not pay its obligations when due). Of course, the first two kinds of risks do not affect money market funds which invest in Treasuries or municipal bonds. But all three risks affect prime money market funds. With a fixed NAV based on amortized cost, investors did not need to track their capital gains and losses, since all of the return of a money market fund is paid out in dividends. In addition, a stable NAV allowed these funds to offer such services as check-writing and the other general features available to deposit accounts, while allowing investors to have access to some upside features. The daily dividend on the fund is based on the accrued interest based on amortized cost. At least that was the situation before the recent amendments by the SEC. On Weighted maturities and interest rate sensitivities. Given the above mentioned advantages of the stable NAV for money market funds, it was imperative to keep the funds within certain risk bounds. One way to do this was to limit the maximum weighted average maturity (WAM) of the funds. An increase in interest rates would decrease a fund’s shadow price. One measure of the sensitivity of any fund with respect to a change in interest rates is the fund’s weighted average maturity (the WAM). The WAM is the measure of the average maturity of the bonds in the fund’s portfolio, and the SEC rules provided that funds, in order to use amortized cost, could have a maximum WAM of 60 days. The higher the WAM, the more sensitive the shadow price of the fund would be to changes in interest rates. When redemption of funds is high, especially in times of crisis, (as was the case between 2007 and 2008), then shadow prices will fall below $1, and the WAM is especially helpful to understand the riskiness of these funds. Recent measures of WAM show relatively low riskiness. Money market funds are obligated to disclose their net assets, 7-day interest rates and WAMs on a monthly basis. Extracting some of this data from the SEC web site for four representative prime money market funds (those of BMO, BNY Mellon, Legg-Mason and Fidelity) show that all of these funds have WAMs well below 60 days. The shadow prices (not shown) are $1 for BMO and BNY Mellon, $1.002 for Fidelity and $1.0001 for Legg Mason in the period shown. Legg Mason, with a WAM over the period for its prime funds of 6 days, carries a 7-day rate on average of .23%. (The figures below come from the N-MFP disclosures on the SEC website). Does this mean there is no cause for concern? The above-mentioned trends do not mean that there is no cause for concern. Shadow prices of these funds are notoriously resistant to reflecting trends in markets. In September of 2008, 90 percent of prime money market funds had shadow prices within 5 basis points of $1, as reported by the ICI. Nevertheless, when floating NAVs become part of the investor’s framework, it is likely that they will not be as volatile as feared if current trends in the weighted average maturity are any indicator. 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.