A Time to Hedge?

The equity market has been ripping higher since the election.  Investors seem to be responding to the possibility of tax cuts for both individuals and corporations and a reduction in regulations that allows corporations and entrepreneurs to move more quickly. The financial media interpreted Friday’s jobs report showing that 235,000 new jobs were created as a positive. Anytime a new job is created we think it is a positive. But to find trends, we have to look at job creation over a longer term period.

The chart above shows new job creation going back to 2012. Over that time period, just over 200,000 people found new jobs each month. So we have not seen an acceleration in job creation yet, which would confirm faster growth in economic activity which would lead to higher incomes and higher corporate profits.

Back on March 8, we posted an article showing that the Fed Funds Futures market is predicting the Federal Reserve will increase the Fed Funds rate later in the week. We think, Friday’s employment report makes the a fait accompli. As investors, we are concerned with the returns on risk assets. Now that we are probably in a rising interest rate environment, what do we think will happen with equity prices? A look at the charts in the context of macroeconomic data gives us a clue.

The top chart above represents the price action of the S&P 500 Index going back about 2 years. Notice that after the election, the share price took off and did not look back. Only recently did the index give us a hint that it may be hitting a short-term peak. Contrast this to the performance of the Russell  2000 Index. It took off sharply after for about a month and has been trading sideways ever since.  Said another way, since the beginning of the year, large cap stocks continued to move strong higher, while small cap stocks traded sideways.

We see this as problematic. If the economy was indeed accelerating, large and small cap stocks would be moving higher together. If we take a step back, the markets may be telling us that a pullback is at hand as investors wait for the details of the administration’s agenda, not the least of which is its tax plan. The administration has released the framework for its modification to the Affordable Care Act. As any political observer might expect, there is no consensus on how the ACA should be modified. Any plan concerning regulation and taxation changes the economic landscape. Those change will create winners and losers, so the political process alway takes longer than one might expect as the various constituencies try to influence the legislation. We do not have insight into how this will play out, but we do know the equity markets have discounted a positive outcome. The question is, “has investor enthusiasm gone too far?”

With a rate hike or two or three ahead of us, now might be a good time to prepare for a pullback in the secular bull market that is underway. If we are reading the charts correctly, we see the potential for the indexes to pull back to the green trend lines indicated on the charts above. If this comes to pass, we think the S&P 500 could fall to the 2,250 area, for a fall of just over 5%. The Russell 2000 could fall into the 1,300 area for a drop of just under 5%.

Our list of open positions is net long the market. We like those positions, as we believe our longs are undervalued, while the shorts are overvalued. Since the market could be poised to pull back, we think investors should consider a “beta hedge.” That is, they should hedge some of the market risk out of their portfolio. How much hedging one does depends on the makeup of their portfolio and their level of risk aversion.

We are not looking for a sharp, brutal correction. On the contrary, we are looking for a pullback that moves lower in fits and starts. In such an environment, we like to be a seller of premium as this increases our probably of success. As a result, we think investors should consider selling a call spread on IWM. We suggest IWM (ETF that tracks the Russell 2000) over SPY (the ETF that tracks the S&P 500) is that we tend to like relative strength or weakness to work in our favor. With IWM trading at $135.96 we suggest the following structure.

When selling spreads, we often do so with “yield” in mind. As a result, we generally sell out of the money spreads. In this case, we are looking for some price protection, so we chose to use an in the money call spread instead. This increases the delta of the trade, but we have to give up some time decay.

To initiate this trade, the investor will collect $3.38 up front per call-spread. The breakeven level is $136.38, which is only slightly above the current price. The efficient market hypothesis suggests there is a 54% chance we will need this hedge. Our analysis, suggests the probably is much higher.  The most one can lose on the trade is $362, which would occur if the share price traded above $140.00 at expiration, which is 3% above the current share price. Said another way, we are risking $362 for a potential reward of $338. But if we do lose on this trade, it is because the overall market worked higher and a diversified portfolio would move higher as well. So one might not have a loss on their overall portfolio, but one would certainly suffer an opportunity cost.