How to Hedge: 3 Ways to Protect your Portfolio

04/20/2016 10:00 am EST


Elliott Gue

Editor and Publisher, Energy and Income Advisor and Capitalist Times

Despite the market’s recent rebound, this is not the time to buy according to Elliott Gue. Here, the editor of Capitalist Times explains the reasons behind his market caution and highlights a trio of strategies to hedge downside risks.

Steve Halpern:  Joining us today is Elliott Gue, editor of Capitalist Times.  How are you doing today, Elliott?

Elliott Gue:  I’m doing great.  Thanks for having me on the show.

Steve Halpern:  Your recent advice to your subscribers cautioned that this is not the time to buy stocks.  Could you walk us through some of the factors that are causing you to remain wary even while the market’s moving higher over the short term.

Elliott Gue:  Yeah, absolutely.  Well, you know, the market’s had a very nice rally since really 2009.  We’ve had a few corrections over that period, but this has been historically a very long-term bull market for the S&P 500 and for stocks in general.

The market -- the S&P -- saw its all-time high last May, so almost a year ago, and we’ve kind of tested that high several times.  Of course, we saw a correction in January, but I see several reasons why I think it’s going to be tough for the stock market to keep going up from here.  

One is simply valuations, the S&P 500 trading at over 18 times trailing earnings, definitely not cheap from a historical perspective.  If we go back through history, when the market’s trading at that level, returns over the next five and 10-year periods are typically very subpar.  

The other major problem I have is the state of the US economy.  At the end of 2015, US economy grew at about 1.4% annualized, which is pretty weak historically for the US, and then in the first quarter, it looks even worse.  

The Atlanta Fed’s GDPNow indicator suggests that US economic growth is going to be less than 0.5% annualized in the first quarter.  This is a very slow rate of growth, and what it means is the US economy is very vulnerable to any shocks.

Further weakening in overseas growth, some sort of a problem in credit markets, which we’ve seen recently in junk bonds, any of that could easily tip us into recession, so I think it’s a very dangerous time to be buying stocks at very expensive levels with all these negative economic backdrops.

Steve Halpern:  Now, with that as a background, you also suggest to your subscribers that they should consider hedging rather than selling out of long-term positions.  For investors not familiar with this, could you explain the overall strategy behind a hedge.

Elliott Gue:  Sure, well, you know, sometimes I’m asked whether it makes sense to see out, you know, if the market’s going to go down, does it make sense to sell out of all of your stockholdings, and many times, the answer is no.  

Some people may have held stocks for many, many years, and if they sell them, they’re going to have large capital gains taxes to pay, or for MLPs, it could be a large recapture, for example, Master Limited Partnerships, so it may be not effective from a tax basis.  

It also may be that, if the market goes up, the market could easily go up another 5%, 6% from here, I’m not saying that’s not possible, so it doesn’t really make sense to necessarily sell out of all of your stockholdings right now, but what you can do is to protect yourself when there’s a decline.  

If you look at all the best investors back through history, people like Sir John Templeton of the Templeton fund family, even Warren Buffett, one of the ways that they’ve beat the market consistently over the years isn’t just by picking the right stocks to buy.

Rather, it’s by staying out of the market or lightly exposed to the market during the big bear markets, so it’s not about not losing money at all, because if the stock market goes down 30%, I don’t care what stocks you buy, you’re probably going to lose a little bit of money in that kind of a decline.

It is about sheltering your portfolio from those declines as much as possible using a variety of hedges, which would be positions that tend to go the opposite direction from the broader stock market, and this can both shelter your portfolio from losses and also provide you with a little bit of cash at the lows when you cash out as hedges to actually buy stocks at bargain basement prices, so that’s what we’re looking to do.

Steve Halpern:  So, let’s look in some of the specific hedges that you think are most appropriate in the current environment, and one of those involves US government bonds.  Could you expand on this and explain the specific ETF that you’re recommending for this purpose.

Elliott Gue:  Absolutely.  US government bonds are the world’s safe haven assets. When everything else is in trouble, when the credit markets are in turmoil, when global stock markets are collapsing, US government bonds are where investors go to hide.  

We saw it back in 2008, which was one of the worst years of the stock market in financial history, certainly since the great depression of the 1930s.  Stocks were down over 30%, but if you got into longer-term US government bonds, you saw capital appreciation upwards of 30%, so you had a 30% gain while the rest of the market was getting slammed.  

This year, I think that though yields in the US are low, they’re probably going to go lower, and the reason I say that is the recent rally in stocks has been mainly predicated on the idea that the Fed is not going to increase interest rates, certainly not at the pace they were talking about at the end of 2015.

And I think it’s quite likely that the next move out of the Fed will actually be a cut in interest rates sometime next year, early next year in 2017.  That’s good news for bonds.  

Bonds tend to go up in value when yields go down, of course.  I like the iShares 20+ year Treasury Bonds ETF (TLT).  Basically, it tracks the performance of longer-term US treasury bonds, which is the group that will go up the most if I’m right and investors are looking for sort of a safe haven asset in a broader market downturn or a US economic downturn.

Steve Halpern:  Now, you also view gold as a way to hedge.  How does gold provide this kind of downside protection, and how would you get exposure to that sector.

Elliott Gue:  Well, gold is an interesting one.  Back in 2008, gold did pretty well.  It certainly held up much better than the broader stock market.  It did get hit along with stocks a little bit in the autumn when the global credit markets locked down.  

What I think though is that one of the main headwinds the market’s going to face this year is that most of the rally over the last several years has been based upon Fed actions and the actions of other central banks around the world.  

For example, back in 2012, we saw financial conditions tighten, particular in Europe, and what happened, the Fed came out with another round of quantitative easing, the European Central Bank came out with various plans to sort of push down yields on Italian government bonds and other fiscally troubled nations.  

We’ve also seen the Bank of Japan very active with quantitative easing and with negative interest rates.  Even just recently, what happened when the market fell apart in January.  

Sure enough, in February, the Fed came out, Janet Yellen came out and started talking dovishly, saying we’re not going to raise rates as much as we thought we were before, we’re concerned about global economic growth.  

The big concern though is that these actions, the Fed and other central banks are sort of running out of ways to stimulate growth solely through monetary policy. We’ve seen it in Japan where their recent decision to go to negative interest rates actually caused the yen to appreciate in value, not depreciate in value.  

Central banks are reaching the limits of their power.  I think that gold is basically a proxy for that.  Owning gold is a way to hedge yourself against the breakdown, or at least the loss of efficacy of all this central bank stimulus we’ve had over the last several years.

Steve Halpern:  Finally, you’re also suggesting that someone could hedge their equity exposure with ProShares Short S&P 500 (SH).  Could you explain what this ETF does?

Elliott Gue:  Sure, this is an ETF that is designed to go up in value by about 1% on a day where the S&P is down by 1%, so if the S&P falls, this ETF goes up in value.  

It’s essentially equivalent to taking a short position in the broader stock market, betting on a decline in stocks without actually having to short anything simply by buying this ETF, so it’s a very convenient way to get short stocks.  

There are some issues with these ETFs in the sense that they’re not perfect at tracking.  In other words, over a longer-term time period, if the S&P is down 10%, it doesn’t mean that the ETF is going to be up exactly 10%. But over the long term, they’ve been a pretty good hedge.  

What I think is a wise move is, when we see rallies in the stock market, maybe consider taking out a position in SH.  Over time, add to that position on rallies and look to take a little bit of money off the table to take profits on that position when the stock market sells off.  

You don’t want to hedge away all of your downside risk.  In other words, the goal of having a hedge like SH isn’t to completely insulate your portfolio from the broader market moves, but it is to sort of soften the blow if we do get a 20%, 25%, or even 30% bear market in stocks.

So hedging a portion of your portfolio, a portion of your market risk exposure using an ETF like SH, I think, will provide you with a lot of capital to invest once the bear markets run its course and there actually are some values out there.

Steve Halpern:  Again, our guest is Elliott Gue of Capitalist Times.  It’s always fascinating talking to you.  Thank you so much for your time today.

Elliott Gue:  Great talking to you as well.

Join Elliott Gue at the upcoming MoneyShow in Las Vegas, May 9th-12th. Elliott will be discussing the stock market winners and losers in the new environment of lower energy prices. Register here.

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