Strategy Update Provided by Jay Pestrichelli and the ZEGA Financial Team
This Sell-Off is What You Prepared For
by Jay Pestrichelli | Dec 18, 2018
For those of you in our Buy and Hedge strategy, this is the market you’ve been preparing for. As the S&P 500 shows a likelihood to post the first negative year since 2009, being hedged with ZEGA is the solution to put a limit on how much you lose during the declines. Those of you that know me won’t be surprised to learn I was a Boy Scout and as we all know; the Boy Scouts moto is: “Be Prepared”. The Scouts Handbook says this means “you are always in a state of readiness in mind and body to do your duty”. While that’s fine for the Scouts, at ZEGA being prepared not only means being in a state of readiness, but planning for the potential outcomes and matching them against your risk limits and return goals.
Buy and Hedge is the exact way we’ve planned to handle the inevitable market sell-offs we’ll all experience during our investing lifetimes.
If you’ve heard us talk about Buy and Hedge, you’ll recognize that we preach, almost ad nauseam, about a max downside stock risk of 8-10% in a single year. Well this might be the year that protection level keeps portfolios safe.
It’s easy to grasp the concept of protection and avoiding losses by hedging. It’s like buying insurance. We all buy insurance. While no one likes having to use it, but you’re glad to have it when there’s an accident. Hedging provides that insurance.
But there’s a second aspect of Buy and Hedge, and it may surprise you. In addition to NOT participating in the full decline of the stock market, Buy and Hedge rewards those that hedge with the opportunity to buy more share of the market while it’s down.
Strangely, this opportunity increases the more the market drops. Think of this as being able to buy the market at a discount when you didn’t have to experience the discount in your portfolio.
We call this activity “re-investing avoided losses”. Oddly enough, there is a perverse incentive for the hedger to watch the market drop as far as it can before re-investing the avoided losses. Let’s say the market drops 30% but your Buy and Hedge portfolio only drops 10%. When your hedges expire, you’re going to have 20% more money now than if you had not hedged and rode the market lower by the full 30%. That 20% can buy more shares while the market is at a discount from the drop. The deeper the drop, the deeper the discount and the more shares you can position for the way back up. That’s what we call the “Hedgers Opportunity”.
The question we ask now is if we will get this the opportunity this time? Will the declines get severe enough that we get the chance to re-invest avoided losses?
I’ve been through 2 full-fledged bear markets. The Dot-Com Bomb in 2000 and the Great Recession in 2008. It was clear during both that fundamental reasons for the declines stemming from the health of corporate balance sheets and over-leverage drove the crashes. While there doesn’t seem to be any major signs of that today and the economy is growing at a high rate, the daily market action, sentiment and momentum feels bearish. If it turns out the market can navigate through theses turbulent waters of a Rate-Raising-Fed, Trade War with China and an Inverting Yield curve, this probably turns out to be nothing. But if something unexpected comes along, the market has demonstrated that it will take negative news and use it to magnify pressure on stocks without prejudice.
Naturally no one ever wants to use their insurance; it means something disastrous happened. But having it lets you sleep at night knowing you’ve got some protection. The same goes for being in a hedged strategy. These multiple days of market declines bring feelings of anxiety and fear; plus, there will be some damage, albeit limited, to even hedged accounts if we go full-fledged bear.
While we don’t make calls or predictions on markets, we’ve made the point again and again that having hedges on your long equity position takes the pressure off trying to enter a market at the right time. Many advisors have clients who invested near the tops of the market. Many of those advisors choose Buy and Hedge because their clients could handle an 8%-10% drawdown but would never risk a 55% peak to trough move like we saw in 2007 to 2009 using plain old unhedged equities.
For those clients who put money to work at the highs for the year, their protection is already avoiding losses, thus presenting opportunities. New money looking to find a home for the assets allocated to stocks in a portfolio would do well to have downside floors in portfolios.
Remember, many investors missed out on gains over the past ten years because of fear which kept them on the sidelines. Participating in market growth is an obvious benefit of the Buy and Hedge approach. The goal remains to have downside protection without taking away the growth potential of stocks. At the same time, should the Bear rear its claws, you have it covered and your insurance claim will take over.
For those of you in Buy and Hedge, don’t despair or fear the selloff. This market decline may provide an opportunity you haven’t had in nearly 10 years. It’s why you picked Buy and Hedge in the first place. It’s what you prepared for.