Time to Buy and Hedge
Although our models told us to hop back on the long side of the market six weeks ago, there are a great many investors out there – individuals and professionals alike – that have missed the current rally. For example, I personally know three investors who make their living in the market that have been either short or entirely in cash during the current joyride to the upside.
In light of the fact that I live in a glass house so to speak, I am most definitely not going to be tossing any stones around this morning. No, my first point is that this rally was an easy one to miss as the volatility in the market prior to the start of the rally had been insane and the macro backdrop was nothing short of ugly. Thus, there were plenty of reasons to avoid stocks at the end of last year.
So, now that the market has enjoyed a pretty decent run, what is the underinvested investor to do? With nary a down day to speak of this year (as we mentioned yesterday, the biggest daily decline for the S&P 500 in 2012 has been -0.57%), should one simply throw up their hands and bomb in? Should investors exhibit patience and continue to wait for a 3-5% pullback? Or is this the time to play contrarian and start betting against the bulls with big short positions?
There is nothing quite like a confounding rally to cause people consternation and confusion. My bearish buddies simply can’t see ANY way that stocks can advance from here. And to give you an example of the confusion/frustration level that is out there amongst those on the sidelines right now, I even had one person ask me yesterday if it was time to go back to a buy-and-hope approach. (To which I politely replied, “Uh, no.”) And while I am fully aware that I’ve been beating this drum a fair amount lately, this is the type of rally that reinforces the idea of utilizing a system for entry and exit points instead of a crystal ball.
Please don’t mistake my message this morning. I am not saying that investors should initiate or even add to positions at this point in time. Heck, my “new money rating” has been “hold” for some time now. Stocks are overbought and sentiment is starting to get a little too optimistic, which tells me that a pullback could begin at any time and for any reason. As such, instead of doing something as silly as returning to the buy-and-hold approach, I think it might be smarter to implement a buy-and-HEDGE approach at times like these.
Let’s say that the relentless march higher is tearing you up inside and you’ve decided that you simply MUST get some money in the game. In short, you can’t take it anymore. So, here’s the plan… Instead of simply buying after a strong rally and hoping that the rally continues unabated from here, it might be smarter to establish a plan to “buy and hedge.”
More specifically, the idea is to buy a portion of your positions now and then establish a strategy to hedge those positions if the market itself goes against you. This is an especially effective approach if you are trying to get into several individual stock positions. So, let’s say you want to pick up some Apple, some Google, and some IBM in the tech arena as well as some Freeport to get your metals fix, and then maybe some consumer names such as Mickey D’s, Monster, and Chipotle. Okay, that’s easy enough.
Now for “hedging” part of your strategy, you’ve got a couple of choices. First, you could write some call options on your positions in order to bring in some income and give your long positions a little downside cushion. However, this approach does limit your upside should the bulls continue to run, and it is important to note that such a strategy can can get more than a little complicated.
The other approach to take is to use “trigger points” to initiate downside hedges in your portfolio. Here’s the plan. First, identify a level in the market that could be a problem on a chart basis such as 1300 and 1280 on the S&P 500. The idea is to use these “trigger points” as signals to put some hedges on your long equity positions via inverse ETF’s.
So, if the market starts to struggle after your buys (this usually happens within minutes of your final buy), you needn’t beat your head against the wall because you’ve got a plan. If the S&P breaks below 1300, you simply add something like a 10% position in the SSO. This effectively covers 20% of your long exposure as the SSO will increase when the market declines. And then if the S&P breaks down below 1280, rinse and repeat. Boom, you’ve got 40% of your longs covered. And then as long as you remain happy with the way the longs are acting you can continue to hold your favorite stocks through a normal pullback.
Yes, I know this is a simplistic approach (I personally will be using my market models as my “triggers” to hedge stock positions). But given what has transpired in the market lately, it just might be time to buy and hedge – just in case the trees don’t grow directly to the sky this time.
Turning to this morning… A strong rally in China and expectations for a deal in Greece has pushed foreign markets higher. U.S. futures are also slightly in the green this morning before the bell.
On the Economic front… There are no reports scheduled for release before the bell today.
David Moenning
Editor: Short-Term Market Manager
