The market has made an enormous move in a very short period of time. The 8% move over the past 6 trading sessions is beyond normal. Unlike the March bottom where we were coming off of extremely oversold levels, the current rally is coming off of only slightly oversold levels. Unlike the March bottom where we said the initial 10% was likely to lead to more follow-through, I am not as optimistic here. The recent move has sent the market into an overbought scenario in a very short period of time. It’s likely that the smart money will begin waiting for a better opportunity to get in. That means we could see the buying begin to taper off in the coming days. I still believe there is no real catalyst to send the market substantially lower, however, so don’t expect the market to fall off a cliff here.
Quick moves like we’ve seen in the last few days never make me feel comfortable. The “better than expected” earnings trade has gotten extremely crowded. As regular readers know, when one side of the boat starts to get too crowded I always like to jump off or move to the other side. At this time, I think it’s prudent to move to a more mildly bullish position, but I certainly don’t feel comfortable getting short at these levels. The risk of near-term downside is very high, however, I would expect any downside to be short-lived and relatively minor. I would expect buyers to come in 3-5% lower from here.
With that said, it’s prudent to throw on some hedges here if you haven’t already. The current JP Morgan strategy outlook provides a relatively good framework:
One of the best ways to hedge potential downside is to write calls on the positions you might own, however, since we’re not all options traders I’ll detail a few other potential ideas. If you’re a small investor without an options account you might consider a fund like PBP which is an option writing S&P 500 fund.
Although JP Morgan likes shorting oil here I have to disagree. I prefer to hedge with non-correlated assets and oil’s correlation to the equity markets is very close to 1:1 in the last few months. I would be more inclined to hedge with fixed income and currency instruments. The simplest hedges are the risk aversion trades. Although the Yen has been my “go to” risk aversion trade over the last few months I currently believe the Yen is unattractive when compared to its alternative risk aversion play: the US Dollar. I would also favor long dated bonds as a risk aversion play. It’s important to note that I like these instruments purely as hedging instruments. On their own I have little conviction. The beauty of using these kinds of instruments is that I am not picking assets, but rather picking correlation. Hedging with non-correlated assets is a lot like being able to pick heads AND tails in a coin flip.
Warren Buffett‘s first rule of investing is “don’t ever lose money”. His second rule is “don’t ever forget rule #1.” Hedging is the art of protecting your downside risk. Of course, those who misinterpret Mr. Buffett’s strategy don’t see the brilliance behind what is essentially a massive covered call approach. Buffett writes billions of dollars of life insurance premiums from Berkshire’s insurance units and then uses the cash flow to purchase equities. Many view his strategy as a pure value approach. I call that the greatest lie ever told to the investing public. The takeaway from this is that Buffett is a genius in not losing money. The primary reason? He is a genius at protecting his gains. I think now is the time for you to do the same.