Is It Time to Hedge Once Again?

The equity markets are at an interesting juncture. After ripping higher since the election, equities, in general, have begun to move sideways. When that process started differs by market cap. Take the Russell 2000 as represented by the ETF IWM, for example. This is an ETF that tracks the performance of small and midcap stocks. It had a sharp move higher until December 2016 and has essentially gone into a sideways trading pattern ever since.

Contrast this to the price action of the S&P 500. The following chart shows the performance of the S&P 500 as represented by the ETF SPY. Notice that the share price moved sharply higher after the election into December 2016 just like the Russell 2000. Shortly thereafter, the two Indexes/ETF parted ways. SPY paused for a few weeks then began a new move higher just as IWM went into its sideways trading pattern that is still going on today. There is one clear conclusion here. Small to medium cap stocks are underperforming large and mega cap stocks. There are far more small and midcap stocks than large and mega cap stocks. So we can also say that the number of stocks participating to the upside is getting thinner. This is a sign of buyer exhaustion and an indication that a correction could be around the corner.

Let us look at this theme a little bit deeper. The following is a chart of the NASDAQ 100 as represented by the ETF QQQ. Ever since the election, this index has simply powered higher without a hint of hesitation. The Nasdaq 100 index is comprised of the stocks of the 100 largest non-financial companies listed on the NASDAQ.

Given that tech companies tend to list on the NASDAQ, this index has a strong tilt toward technology companies. This sector represents 52.4% of the index. It has another strong tilt as well. It is highly influenced by 5 Mega Cap Technology stocks (Facebook, Alphabet, Amazon, Apple & Microsoft). These 5 names alone represent 35.74% of the index. As the following chart shows, these stocks have been huge performers over the last 4 years.

Source: Zerohedge

In 2013, the market cap of these names was about $1.1 billion and has grown to about $2.9 billion currently. This is about 164% or 27% annualized increase since the low of 2013. (Notice that the vigor of the rally accelerated somewhat after the election.) The actual returns to shareholders have actually been higher than that. There has been share repurchases and dividends paid over this time period as well. There are some other stocks that have taken the index higher as well. NVIDIA is up 500% since the beginning of 2015. The point of this analysis is that the equity markets have become a “winner take all” affair. The mega-cap tech stocks outperformed everything. General large-cap stocks have outperformed mid and small cap stocks. We see this as a sign of a peaking market. If we were in the middle of a bull market the gains would be more spread out.

We are not looking for a bear market, simply a decent size correction that shakes out the levered bulls. This would set the stage for the next leg up. We know investors are complacent. We have written about the VIX trading at historical lows and levels that were last seen in 2007. The only concern is that we are not alone in our expectation for a correction. Analysts and various financial journalist have been talking about a pullback for some time, so it is possible we do not get it. On the other hand, if we do get a pull pack, investors may not sell initially as they may expect it to be short and shallow. So a 4% pullback may not create the bearish sentiment and selling we are expecting. It may take something a little larger like a 6 to 8% selloff to set the stage for the next leg higher. In short, the outcome we experience may be a bit more binomial.

If you agree with our thesis that a correction is over the short-term horizon, you might what to consider a partial hedge for your portfolio. Most of us are net long the market. Indeed, those that only buy stocks and ETFs and carry little cash are close to 100% long. A partial hedge may make sense, as it will take some of the sting out of a selloff. Investors would still lose some value in their portfolio, but not as much as if they were unhedged. If on the other hand, stocks power higher, investors accounts will still appreciate, just not as much as an unhedged portfolio. When performing a hedge against a market decline, we like to take a bearish position on the weakest index/ETF. In this case, we would focus on IWM. With this ETF trading at $139.21, we would sell the following call spread.

In this case, we are choosing to sell a call that is somewhat in the money to get a little extra “delta” which is a measure of the sensitive of the option position with respect to the underlying instrument. At the same time, we want a little negative “theta” to allow us to capture some income in the event that trading remains flat for another month. One collects $251 collects per spread upfront when placing the trade, which they get to keep if the share price falls below $138 at expiration, which is about 1% below the current price. The most you can lose on this hedge is $349, which would occur if the share price rose above $144 at expiration, which is 3.4% above the current price. The breakeven level is $140.51, which is about 1% above the current price. The efficient market hypothesis suggests there is a 59% chance to profit on this trade.

We know that the market has been a bullish mode since the bottom in 2009. As a result, you need to be aware that by hedging, you are leaning against the wind a little bit. If we look at the historical distribution of potential outcomes for a 36 day holding period, we see there it a 47% chance of success on this hedge.

The last time we suggested a hedge was on 12-March-2017. To read that article, click here. We let the trade run until expiration for a gain of $166 per short call spread. Since the markets appeared to be showing some strength at that time, we chose to release the hedge and not roll into a later expiration. This turns our to be fortuitous as IWM rallied by about 5.5 points since then.