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I have previously detailed multiple methods for hedging equity portfolios using ETFs. During periods of market drawdowns or corrections, it is helpful to ask yourself if “now” is the time to either hedge or sell your long positions or if further patience is warranted until further confirmation of a more significant drawdown.
Hedging in its simplest form is purchasing securities in order to reduce portfolio risk. The purchased securities are intended to have negative correlation to the remainder of the portfolio in order to help offset any potential losses in the portfolio. Holding uncorrelated assets, such as stocks and bonds, are one of the most popular methods for reducing portfolio risk since historically stocks and bonds are relatively uncorrelated.
However, there are alternative methods for hedging portfolio risk and multiple methods for timing one’s long and short positions. This article asks if now (May 27th) is the time to buy/hold US equities or sell/hedge an equity portfolio based on 3 of the strategies I detailed here.
Strategy #1 – Moving Average
One of the more popular methods for minimizing downside risk and one I track frequently on Scott’s Investments is to exit long positions when they fall below a long-term moving average. This may not technically be a hedge, since the entire position is exited. However, as Faber showed in The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets, it is an effective method for reducing volatility and risk in a portfolio.
There are other options for investors who hold individual equity positions and hedge. For example, say you hold a position in two stocks, ABC and XYZ and wish to hold both stocks for the long-term. However, the overall equity market has you a bit nervous and has recently begun to struggle, showing signs of weakness. One option would be to short the overall equity market and one of the simplest ways to do so would be via a 1x inverse ETF such as SH (Proshares Short S&P 500), which seeks daily investment results that correspond to the inverse of the S&P 500 Index. You could also use an inverse small cap, international, sector, etc. ETF depending on the long positions you currently hold.
For backtest results of one variation of this strategy, please visit my study here, which has avoided a down year (including 2008!) since data was available (2000). What is the strategy telling us today? There are numerous variabilities to consider, primarily the moving average length an investor wishes to use and the index or trading vehicle an investor wishes to use as an indicator.
Using the 10 month SMA for some widely followed ETFs, we do not yet see a “sell” or “hedge” signal, nor do we see sell signals using the 200 day moving average:
SPY (SPDR S&P 500) – Currently above 10 month & 200 day moving average
EFA (iShares MSCI EAFE Index) – Currently above 10 month & 200 day moving average
EEM (iShares MSCI Emerging Markets Index) – Currently above 10 month & 200 day moving average
IWM (iShares Russell 2000 Index) – Currently above 10 month & 200 day moving average
Strategy # 2 – Relative Strength
Using ETF Replay, we can compare the relative strength and volatility of ETFs and backtest various ETF strategies. One strategy previously tested was to combine a long ETF portfolio with a position in either SPY, SHY(iShares 1-3 Year Treasury Bond, used as a proxy for cash or a relatively neutral position) , 0r SH. The position in SPY, SHY, or SH would be determined by which of the 3 ETFs had the highest relative strength.
On May 27th this strategy switched to SHY, or cash. Thus, if an investor used this strategy to determine when to go long, short, or neutral, the current signal indicates a neutral/short-term bond position based on relative strength. We will keep an eye on this indicator for either continued weakness, which could lead to a short signal, or a reversal to a long position in SPY.
Strategy #3 – Market Conditions & Market Valuation
A third hedging strategy is to based long/short positions on overall market conditions. There are a myriad number of ways to gauge “market conditions” and how one hedges these “conditions” depends on your time-frame and current portfolio. However, assume we hold a portfolio of US equities or US equity ETFs and wish to hedge them during “unfavorable” market conditions.
Doug Short tracks the P/E Ratio Market Valuation to gauge current market valuation on a long-term basis. The S&P 500 is currently overvalued based on its price to earnings ratio. Ideally, we could employ a hedge or avoid long positions altogether when the market is “overvalued”. However, markets can stay over and undervalued for lengthy periods of time, sometimes years. Thus, basing a hedge on relative long-term market valuation alone can be a costly and lengthy experiment.
Stockscreen123 has devised a timing system suitable for longer term investors that has historically still reacted quickly enough to serve as a hedge during unfavorable market conditions. The system uses 2 factors to determine “market conditions”:
It assumes conditions are favorable for equity investing if EPS estimates are rising and if valuations are reasonable.
- The estimates test is whether the 5-week moving average of the aggregate of the consensus current-year estimates for S&P 500 companies is above the 21-week moving average.
- The valuation test is based upon risk premium, specifically, whether the S&P 500 risk premium (earnings yield minus 10-year treasury yield) is above 1%
When conditions are “favorable”, one would be long equities (hold SPY) and during unfavorable conditions, short equities (hold SH). The strategy currently indicates a position in SPY.
In conclusion, we currently see some mixed signals. Relative strength is weakening in SPY but equities remain above long-term averages and market conditions remain favorable for the time-being, even though the market is currently overvalued. Discipline is essential in investing – research data and strategies and then devise a strategy you feel comfortable with and consistently follow the signals to avoid the emotional aspect of investing.
Return discussed exclude commissions/taxes