If you have followed my newsletter for a while you might remember the recent description of hedging with “shorts” being investments that go up when a something else goes down. Shorts act opposite from “long” investments which are what most of us are used to. Longs go up and down in sync with the market as you would normally expect.
Almost 9 years ago, when I first used this strategy that included shorts in client accounts, I was asked why on earth would I hold both a long and a short at the same time if they tend to cancel each other out, and I found it was a very difficult concept to covey. But, since you will see these short investments in your accounts, under names like Bear or Inverse or Short, I though I would try to explain the strategy involved.prices
When markets become volatile and experience large price swings, we often wish for a smoother ride. If you have ever been on a cruise boat in rough seas, you know why we all prefer smoother waves. Most investors are the same way toward the ups and downs of their accounts. No one likes wild ups and downs, because sometimes the downs can get carried away causing painful losses. As a manager I have learned to recognize increasing volatility as a sign that things are changing. Sensitivity to this is important after a good run like the markets have had the past few years, because increasing volatility is a sign that signals change from a good market to a poor one.
A month or so ago, I began selling off weaker holdings as volatility increased, raising cash in the process. Volatility increased dramatically toward the end of July, and I began using some of the cash to buy shorts to hedge away risk in all four of the growth portfolios mentioned above. The first hedge was bought on July 24; only three trading days after the market peaked and began down. I think this testifies favorably to the sensitivity of the indicators I use for you.
I have since added more hedges – short positions – in amounts calculated to offset the risk of a market decline in the remaining “long” positions. The goal is to have portfolios be only minimally affected by the market’s moves without needing to sell all of your investments. This is called going “market neutral”, which is what I have done in all of my portfolios to some extent. One of the advantages of a long/short strategy is that we don’t have to make major portfolio decisions in fast moving market conditions to reduce risk. It also reduces the amount of trading activity in the accounts.
In a perfect world of market-neutral hedging, if our long positions are the strongest in the market at the same time that the weakest investments are shorted we may make money for you regardless of what direction the market goes.
Risk is very high right now, so my goal in this market environment has shifted to preserving the value of your accounts with growth as a secondary objective.
I was on the road last week, but with my trusty laptop, I still managed to make changes to hedge all of our growth portfolios sitting in airports and hotel rooms. Ahh, technology. I love it.
The title of this article should give you a hint of where I’ve been this summer, don’t ‘cha know. Yah, sure, I’ve been in Minnesota and Wisconsin, you betcha!
More Caution Signs
A year and a half ago I mentioned that I expected High Yield bonds, affectionately called “junk bonds” by some, to lose momentum and head down. It took longer than I expected, and my Tactical High Yield strategy posted two good years in the mean time, but the downtrend in junk began about two months ago and is really picking up steam.
I consider the junk bond analysts to be among the best in the business as junk often turns up or turns down well in advance of the stock market. My concern now is that this current decline is so steep. After the few similar declines in junk’s short history the stock market experienced a significant correction or bear market decline, defined as a drop of 20% or more.
No one knows for sure what will happen, but the steep decline in junk bond funds suggests that this decline in the stock market may be the initiation phase of a more significant decline. As mentioned elsewhere in this newsletter, I have already positioned your managed accounts to weather the storm and preserve capital for the buying opportunity that will follow. If you share my concerns and you have investment assets that I do not actively manage, I think it would be wise for you to take some action to protect them from a potential sharp decline in value.
You are welcome to call me to talk over your situation if you are concerned. The number is 778-4000. This might be a good time to tell your friends about the risk reducing benefits of active management and have them call me too. There is no charge for initial consultations.