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Don't trust the rally? Hedge your bets
Even if markets continue to climb, which is likely, a long-short strategy takes advantage of the dips. Doubters have a choice: options or a bear fund.
By Timothy Middleton
You need proof its a bull market? The dollar is going down like shots and a beer, but investors are tanking up on American stocks.
You know the dollar is depreciating, you know you can get better interest rates in Europe, but you say, I dont care: Im staying in the United States. says George Friedman, chairman of Strategic Forecasting in Austin, Texas. Were very negative on Asian markets, and not optimistic on European markets. But the American market is just fine.
Since it bottomed on Oct. 9, the Nasdaq Composite ($COMPX) has soared about 46%, with more than half of those gains coming since mid-March. And if a crack is coming, plenty of people don't see it.
The market looks terrific here, says Liz Ann Sonders, chief investment strategist of Charles Schwab. The path of least resistance is still up.
But not necessarily straight up. This is a great time to be in the market, but a dangerous time to go into the market. If 1999 and 2000 taught us anything, it's that extreme rallies are followed by extreme retreats. And this time around, bonds won't provide refuge: They have nowhere to go but down.
Buying protection
So some investment advisers are cautioning their clients to prepare for trouble. Adviser Robert Isbitts of Weston, Fla., is buying put options on the Standard & Poors 500 Index ($INX), a position that will spurt up if stocks head down.
Tom Grzymala, an adviser in Alexandria, Va., just sold Cisco Systems (CSCO, news, msgs), which enjoyed a big run-up in the rally. I think this is a wonderful company, but its reached my target price, and nobody ever lost money taking a profit, he says.
Personally, Im letting cash accumulate while I wait for the market to digest its gains. Extremely nervous investors might want to do more: Adopt a long-short strategy that in effect turns their portfolio into a hedge fund.
I think we find ourselves in a cyclical bull market inside a secular bear market that has many more years to run. I expect stocks will yo-yo between peaks not too distant from here and valleys in the neighborhood of those we visited last October.
If that happens, a long-short strategy is the lowest-maintenance way to steadily tack on equity profits, albeit of a modest size.
Most observers feel todays market sensibly reflects that the United States is emerging from a mild recession. Exchanges are awash in liquidity, all sectors are participating, volume is high, war is behind us and corporate earnings are headed up.
Big gainers
Technology stocks are the most obvious beneficiaries of a rally, both because capital spending will surge in a recovery and because tech bears are in full flight. The average tech mutual fund has been the strongest in the market this year, with gains above 20%.
There arent that many sellers now. The weak hands have been taken out by the bear market, and theyre in strong hands now, people who are going to hang on, says Jack Bowers, editor of the Fidelity Monitor investment newsletter.
Also, he says, A large part of whats pushing tech up is people buying to cover their shorts. Last winters tech shorts have been wiped out by big moves among individual tech stocks.
Yahoo! (YHOO, news, msgs), Amazon.com (AMZN, news, msgs), Ask Jeeves (ASKJ, news, msgs), Priceline.com (PCLND, news, msgs) -- the same suspects of the 1990s have again found themselves up a thousand percent! exaggerates Rica Edelman, author of "What You Need to Do Now." We have seen a complete return to Internet mania.
When prices shoot up like this, its time to hit the exits. Thats why Grzymala, president of Alexandria Financial Associates, bailed out on Cisco. He put the proceeds into defensive stocks -- Kimberly-Clark (KMB, news, msgs) and Altria (MO, news, msgs), consumer products companies that pay above-average dividends.
You also get the dividend (tax) breaks, so thats good money there, he says.
The next slump
But with an election year approaching and both fiscal and monetary authorities pumping tens of billions into the economy, any looming slump is likely to be shallow and short-lived. You dont want to be turning your portfolio over too much, because the next three years will be positive, asserts Isbitts, president of Emerald Asset Advisors.
Rather than selling anything, Isbitts is hedging client portfolios by buying put options on the S&P 500 index. In mid-June my broker, Charles Schwab (SCH, news, msgs), was charging $1,990 for one-month options with the then-current strike price of the index, 995, which translates into $99,500 worth of stock coverage.
If the market goes down 5% before they expire, in mid-July, their owners will get a check for $4,975. A 10% drop would yield $9,950 -- nearly wiping out losses experienced by the portfolio itself.
If the market were to go up, the option would expire worthless but your portfolio would be higher.
But hedging like this is an expensive strategy. The annualized cost of monthly hedges amounts to 20% or more of a portfolios assets. A 12-month hedge in mid-June cost 7% of the assets it's designed to protect.
But Isbitts doesnt hedge for a year. He hedges for one month, or maybe two, only after the market has had an extreme run-up.
A prudent bear
Some of Isbitts most cautious clients are adopting the long-short strategy. For them, he recommends a mix of two-thirds conventional equity funds and one-third Prudent Bear Fund (BEARX).
Run by David Tice, a gloom merchant who thinks the U.S. economy is terminally addicted to debt, Prudent Bear shorts indexes like the S&P and stocks like Cisco, and reliably goes the markets opposite. It's down about 13% this year. But over the three years ended May 31, it was up 21.5% annually, while the market was down more than 10%.
If you had implemented this strategy five years ago, you would have missed the huge gains of 1998 and 1999, but also the even bigger losses of 2000-02. In the five-year period ended May 31, Vanguard 500 Index (VFINX) went down 1.09% a year, and Prudent Bear went up 4.67%. A mix of two-thirds of the former and one-third of the latter would have yielded annual gains of 0.98%.
And this was when stock prices were falling. If, over the next five years, the trend is modestly higher, the same mix would produce greater returns, and with little risk your capital would shrink significantly.
You could have done far better than this mix over the last five years in bonds, but that will be much harder to do going forward. Five years ago, the federal funds rate stood at 5.25%. Now its 1%.
Five years from now, it is much more likely to be in the middle single digits again, and each one-point rise in rates costs the average intermediate-term bond fund 4.1% of its value -- almost exactly such a funds current yield, suggesting future total returns of zero.
Not for new investors
Im more inclined toward the options hedge than Prudent Bear, but options can be more difficult to implement. For one thing, you cant trade options in a retirement account, such as a 401(k) or an IRA. Even in a conventional taxable account, you have to be certified as a sophisticated investor; many and possibly most options expire worthless, costing their owners 100% of their investment.
In my own account, I havent installed an options hedge; for one thing, I dont trade ahead of my column. I am sitting on a small amount of cash, which I expect to invest before the end of the year. My fund portfolio is unchanged. Like Isbitts, I expect the market to be higher in three years, and in 10 years, and I dont need the money before then.
At the time of publication, Timothy Middleton owned the following securities mentioned in this article: Cisco Systems.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
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