Markets

THIS Is Why We Hedge

By Charles Sizemore  |  December 11, 2018

The Dow dropped more than 500 points on Monday… only to finish the day in positive territory.

Now, even a few months ago, a massive swing like that would have been news. It would have had investors swapping stories and likely high-fiving each other.

These days, it’s just par for the course.

In fact, Monday’s swing was comparatively minor. Last Thursday saw a 710-point intraday rally that left investors believing that maybe – just maybe – the worst was behind us. Of course, this was followed by a nasty 559-point drop on Friday.

Wild swings are the order of the day.

Whenever we see moves like these, investors are hardwired to look for an explanation. They want to know why the market cratered or why it blasted higher.

Was the arrest of a Chinese executive that signaled a worsening of the trade war that pulled the floor out from under the market? Or was it softer language from a Fed speech that lit the fuse for a rally?

Whenever I hear explanations like these on CNBC, I want to reach into the TV and condescendingly pat the anchor on the head like a child.

That’s simply not how markets work.

Stock prices work just like any other competitive auction. When there are more buyers than sellers, prices rise. When there are more sellers than buyers, prices fall.

For the past two months, there have been more sellers than buyers, which is why the general direction has been down. But beyond that, corrections and bear markets also tend to be a lot more volatile than healthy bull markets. Everything gets more extreme. Stocks fall harder on down days and shoot higher on up days, and intraday swings gets larger as well.

Some investors choose to simply buy and hold and ride out rough patches like these. Most corrections tend to be short and relative painless, after all, so why bother selling to try to avoid downside if you’re just as likely to instead miss the upside when the bull market resumes?

That sounds great, of course. But some of those relatively painless corrections end up sliding into full-blown bear markets like 2008 or 2000 to 2002.

Rather than ride it out and hope for the best, some investors prefer to dump everything and sit in cash until the coast is clear.

That sounds great too. The problem is knowing when to get back in. Excess conservatism can cause you to miss major rallies when corrections turn out to be a lot shallower than feared.

In my trading service Peak Profits, I split the difference. When my model flashes warning signs, I neither close my eyes and hope for the best nor pull the ripcord and eject.

Instead, I hedge. I reduce my usual position sizes in the value and momentum stocks I recommend by half. I then use the 50% of the portfolio that is free to take a short position in the S&P 500.

So, instead of running an aggressive long-only stock portfolio, I run a hedged, market-neutral portfolio. At this point, the market can go up down or sideways, and I’m prepared for it.

Let’s say the market tanks on me. No problem. My portfolio’s value and momentum stocks might take a hit, but any damage is offset by the returns I earn from the short position in the S&P 500.

Likewise, it’s perfectly fine if the market rallies. Sure, I’ll lose money on the short position in the S&P 500. But my value and momentum stocks should enjoy a nice bump.

The important thing is that I don’t have to guess the direction of the market.

I simply have to choose a portfolio of attractive value and momentum stocks that are poised to either gain more or lose less than the S&P 500. And once my model signals that the worst of the correction is over, it’s back to business as usual. I close out the short position and increase the position sizes in my value and momentum stocks to their regular levels.

If running a hedged portfolio sounds like a sensible middle ground to you, check out my Peak Profits service. In over 20 years of extensive backtesting, including two of the worst bear markets in history in the dot-com crash and the 2008 meltdown, the strategy returned more than 40% per year

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Charles Sizemore

Income and Retirement Strategist, Charles Sizemore, CFA specializes on dividend-focused portfolios and building alternative allocations by finding value opportunities outside of the mainstream stock market.

Charles is the executive editor and portfolio manager for Dent Research's premium newsletters, Peak Income and Peak Profits.

He is also a frequent guest on CNBC, Bloomberg TV, Fox Business News and Straight Talk Money Radio, and has been quoted in Barron’s Magazine, The Wall Street Journal, and The Washington Post. He is a frequent contributor to Forbes, GuruFocus, MarketWatch and InvestorPlace.com.

Charles holds a master’s degree in Finance and Accounting from the London School of Economics in the United Kingdom and a Bachelor of Business Administration in Finance with an International Emphasis from Texas Christian University in Fort Worth, Texas, where he graduated Magna Cum Laude and as a Phi Beta Kappa scholar. MORE FROM AUTHOR