February 19, 2021
By Steve Blumenthal
“Infrastructure spending is the one major area of agreement,
and with Modern Monetary Theory, soaring federal deficits and debt
are no obstacles. More federal stimulus is likely but worried consumers
will probably use most of it to rebuild assets and reduce debt,
as they did last year. Consequently, further economic weakness
is likely in the first half of this year. With global supply continuing to exceed
worldwide demand, deflationary pressures will persist.”
– A. Gary Shilling,
President, A. Gary Shilling & Co., Inc., (INSIGHT, February, 2021)
Last week we took a look at the median P/E of the S&P 500 Index and high-yield junk bonds as market indicators. If Gary Shilling, David Rosenberg, and Dr. Lacy Hunt are correct, don’t expect a bump up in earnings. I want to touch on valuations and high-yield bonds again today, as they tie into the discussion on hedging that I’ve been promising you for several weeks. How to hedge with put and call options is the subject of today’s OMR.
Think of option hedging the way you think about buying homeowners insurance. It is an out-of-pocket expense you’re generally comfortable paying, even if you never use it. If there is a big event, you pay a little and the insurance company covers the majority of the loss––making it very much worth your while. Put simply, there is risk in homeownership, and homeowners insurance helps mitigate some of that risk. Our friends in Texas (and elsewhere) are dealing with freezing pipes, water damage, and other issues none of us would have imagined a few weeks ago. It’s really tragic… please know we are thinking about you.
We know all too well that there is risk in the equity markets too. Generally, once or so a decade, markets crash (and valuations reset). I argue in my book, On My Radar: Navigating Stock Market Cycles, that there are times to play defense and times to play more offense. Valuations can give us some insight into which strategy might be best. Hedging with put and call options can help you when it’s time to play more defense than offense.
What I like most about Ned Davis Research’s median P/E chart is that it helps us set targets to know when coming 10-year returns will likely be high or low.
GMO is out with their most recent 7-year Real Return Forecast. Focus in on U.S. Large Cap as that is what we’ll focus in on today in terms of hedging. However, everything is negative except EM Value and even that’s not so good. Clearly, in my view, it’s time to play defense.
The S&P 500 Index is at 3,925 today (February 19, 2021). It was at 3,714 on January 31, 2021. Note the “we are here” red arrow in the following chart. Focus in on two downside targets: 2,700 (overvalued target) and 2,053.97 (fair value target).
If you buy the argument that valuations have rarely been this far above “fair value” (orange line), then you may agree with me: Now is the time to hedge (especially if you have a low cost basis and selling would create a large capital gain), or take some profits (never a bad idea but who needs the tax headache).
Option Hedging 101
Let’s look at hedging or buying insurance using stock options to protect against a decline back down to “fair value,” or 2,000 on the S&P 500 Index.
First some information to help you get your bearings: SPY is an ETF that tracks the S&P 500 Index. When the S&P 500 Index is at 3,926, SPY is at approximately $392.60 per share. The next chart is a screen shot with green and red notations.
Here’s the basic hedging idea:
- Let’s say you believe the market is likely to decline to 2,000 in the S&P 500 Index or $200 per share in SPY between now and late December 2021.
- For insurance, you buy a put option, which offers some protection. In this case, you are willing to accept the first 10% decline, but then want protection if the market drops another 43% down to fair value. Everything below the red line in terms of loss in the next chart is covered. You can only lose 10%.
- The put (insurance) costs you approximately $21.35 per share. That’s about 5.45% of your $392.60 investment in SPY–– pretty expensive insurance.
- To offset some of that expense, you sell out-of-the-money call options, which are 10% above the current price. Simply, you don’t believe the S&P 500 will gain 10%, from $392.60 to $431 per share by late December 2021, so you sell the options and collect a credit of approximately $11.43 per share. (Now if SPY goes higher, you can do some things to manage your hedge to make sure your stock doesn’t get called away from you.)
- Selling the call and buying the put makes your total cost for the hedge approximately $10 (11.43 in credit – 21.35 in debit = approx. $10).
- For an insurance cost of approximately 2.55%, you are hedged against a decline of more than 10%. Not a bad trade-off.
Someone else may say they are comfortable losing the first 15%. In that case, the cost to hedge is the difference between $17 and $11.43, or approximately $5.57 per share. In this case, it costs 1.42% to insure against a big drop between now and December 2021. You’re deciding to risk 15% instead of 10%.
Let’s say you think a decline to 2,700 is probable, but you don’t believe a drop to 2,000 is likely. You can add one more layer of creativity onto your approach and do it in such a way that the hedge costs you nothing; you actually receive a credit. The point is that what is right for you may be different than what is right for someone else so know there is flexibility in how you design a structure best for you.
With all that said, trading options is not for everyone. It requires time and attention. As such, it is best if you have a trained eye and skilled execution partner to help you manage your risk.
And hedging can get specific; for example, you can hedge your Apple stock or your Emerging Market ETF.
I promised a short video webinar introducing the idea of using the options market to hedge your downside risk exposure. You’ll find two videos below. The first is a discussion with Micah Wakefield. Micah is managing director of research and product development at Swan Global Investments. Swan manages more than $2 billion in option hedging strategies via managed accounts, mutual funds, and ETFs. The second is with my good friend David Beth, co-founder and partner of WallachBeth, and his chief market strategist, Ilya Feygin. Note: my firm works with both Swan Global Investments and WallachBeth, so please know that conflicts of interest exist. Important too: This is not a recommendation to buy or sell any security. I just think most investors don’t know such a strategy exists and now is about as good as a time as any to learn. I hope you find these short presentations helpful.
High-Yield Junk Bond Market – What You Don’t See Going on That’s Going On
One more follow-up on last week’s OMR post. I read an excellent article in the Financial Times this week that I hope can give you a sense for how zero interest policy has enabled some bad behavior that will eventually hurt investors, IRAs, 401(k)s, and pension plans stuck holding the bag when the party stops.
“More than 15% of debt raised in the U.S. high-yield bond market has carried a rating of CCC or below, the lowest ratings given, since the start of 2021. That’s the highest share since 2007.” (FT)
OK. In English, lesser-quality companies are able to find funding at terms favorable to them and less favorable to you and me. Here is an example: “Leveraged buyout firms have also used the strong demand to cut themselves bumper cheques from the companies they own. Innophos Holdings used a risky type of debt called a payment-in-kind note, which allows it to make interest payments with an IOU instead of cash, to raise $175m. It used the money to pay a dividend to its private equity owner One Rock Capital, which bought the company last year.” (Source: FT)
Venture capital firm buys a company using some of their equity and some debt. The company hires an investment banker and issues a new bond. The rating agency details the risks, giving Innophos Holdings bonds a low CCC rating. Investors, desperate for a higher yield due to the Fed’s zero interest rate policy, buy Innophos Holdings bonds (individuals, ETFs, and MFs flush with new cash from investors seeking higher yields). Innophos Holdings does not use the money to expand its business, improve its balance sheet, hire new employees… No, wait for it… The money passes through them to pay a dividend to its private equity owner.
“Nothing personal, it’s just business.”
– Otto Berman, Accountant for American Organized Crime
“If a man is dumb, someone is going to get the best of him, so why not you?
If you don’t, you’re as dumb as he is.”
– Arnold Rothstein, Racketeer, Businessman, and Gambler
“There’s no such thing as good money or bad money. There’s just money.”
– Lucky Luciano, Gangster, Mob Leader
“Judges, lawyers, and politicians have a license to steal. We don’t need one.”
– Carlo Gambino, Crime Boss
It’s legal. They can do it. But fools are stepping in and won’t know what hit them until the party ends. No one knows when, of course. I can see the private equity fund managers sitting in front of some congressional committee in Washington in the not-too-distant future.
The high-yield bond market has an excellent history of providing early warnings. I’ve shared the next few charts with you before. Keep them on your radar. Here’s what to watch out for:
The following chart dates back to 1998 and tracks the daily price of the PIMCO High Yield Fund. The green line is a 50-day smoothed moving average trend line. A buy signal occurs when the price line rises above the moving average line. A sell signal happens when the price drops below the moving average line.
- The 2000-02 Tech Bubble. The PIMCO fund declined approximately 33%.
- The 2008-09 Great Financial Crisis. The PIMCO fund declined approximately 33%.
Here is the same chart looking at the last two years. If one were to use the 50-day moving average cross rule to signal risk-on vs. risk-off, this is what it would look like. By this measure, the high bond market is in a risk-on trade. By the way, this is a strategy known as trend following.
The next great crisis will present a fantastic return opportunity for high yield bonds and equities as well. I’ve traded through three of them since the early 1990s. Number four will be epic. No guarantee… but I’m preparing my clients for it.
Note that this is not a perfect system. There will be some whipsaw trades. Patience is required. Having the guts to execute is mandatory. The best opportunities present in crisis. It won’t feel like an opportunity, but it will be.
Side note: My personal HY trade signal is a bit more sophisticated than the 50-day rule, but as you can see in the charts, the 50-day is pretty good way to help you measure and manage risk. The bottom falls out when liquidity dries up. The HY market provides an early warning.
While the vultures are pillaging what the Fed’s easy money policy has enabled, I don’t want to leave you with a pessimistic feeling. I’m only pessimistic on overvalued equities and low-yielding bonds. Hedge the equities and completely rethink how you’re allocating to bonds. We are seeing some outstanding opportunities in other areas.
John Mauldin is CMG’s chief economist and co-portfolio manager of the CMG Mauldin Portfolios Platform. He recently wrote a paper titled, “What’s In Your (Investment) Kitchen?” I believe it will give you a sense of optimism. A sense that there is a way to intelligently navigate the period ahead. If you are an accredited investor or independent investment advisor, you can access it here. We’ll ask you for some basic information and then you can download the paper.
Grab a coffee and scroll down. You’ll find the two option hedging conversations I hosted and a link to the most recent Trade Signals post.
If a friend forwarded this email to you and you’d like to be on the weekly list, you can sign up to receive my free On My Radar letter here.
Included in this week’s On My Radar:
- Option Hedging 101 – Micah Wakefield, Swan Global Investments
- Basic Options Hedging Discussion with WallachBeth
- Trade Signals – Equity Market Momentum Continues As Treasury Yield Rises
- Personal Note – Double Your Failure Rate
In this short video webinar, I talk with Micah about the basics of hedging.
Not a recommendation to buy or sell any security. Please reach out to me if you have a large stock portfolio with low-cost basis stocks and are looking to learn more.
Here, I interview David Beth, co-founder and partner of WallachBeth, along with Ilya Feygin, WB’s chief market Strategist. We go deeper into the specifics of option hedging and I’m confident you’ll walk away with a better feel for how it all works.
Not a recommendation to buy or sell any security. Please reach out to me if you have a large stock portfolio with low-cost basis stocks and are looking to learn more.
February 17, 2021
S&P 500 Index — 3,918
Notable this week:
As you will see in the Dashboard of Indicators below, the equity and fixed income signals are largely unchanged from last week’s post. The Ned Davis Research Daily Trading Sentiment Composite increased to indicate “Excessive Optimism,” which is a short-term bearish signal.
We note that the U.S. benchmark 10-year bond yield rose to 1.3%, its highest since last February, while the 30-year Treasury yield at 2.1% is now higher than it was a year ago.
Tim Hayes, CMT, Chief Global Investment Strategist, and Anoop Nath, CFA, Global Analyst, of Ned Davis Research, write in a recent report that, “Expectations for ongoing monetary and fiscal stimulus have continued to push bond yields higher, sending the Barclays Global Aggregate Bond Yield to its highest levels since March. The continuation of this trend will have major implications for asset allocation if it starts to change intermarket relationships, as indicated by one-year correlations.” (Emphasis added.)
Not a recommendation for you to buy or sell any security. For information purposes only. Please talk with your advisor about needs, goals, time horizon and risk tolerances.
Click here for this week’s Trade Signals.
“If you want to succeed, double your failure rate.”
– Thomas J. Watson, Late CEO of IBM
Fail, fix, try again. The great sports coaches preach this idea. It’s how we improve.
Brian Gilman from Virtu Financial puts out an excellent morning market note each day. My first read of the day is David Rosenberg’s “Breakfast with Dave.” Then I read Brian’s note to get caught up on the overnight global activity. Brian adds some additional color on ETF capital flows.
The quote above, which Brian shared, caught my eye, and I smiled thinking about my Susan and her constant message to the kids she coaches: “Double your failure rate.” A hat tip to Brian.
Not only is failing more frequently a faster path to getting better, the hidden message is really liberating: Don’t be afraid to fail in the first place.
I also wanted to share another important message from Brian’s note: Today is National Chocolate Mint Day. “Chocolate and mint are a phenomenal combination and thinking about it is a good way to go into the weekend. Think I’ll scoop myself some mint chocolate chip ice cream tonight…” Brian wrote. I think I might too…
I’m going to make tomorrow Steve’s National Dark Chocolate Kit Kat Bar Day. Forget the cheese, I had my first one yesterday and it pairs very well with a fine French Bordeaux. I know, I know… but it really does. 😉
Wishing you a great week.
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
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Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.
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