Hedging against a bear market

April 23, 2021No Comments


Hedging Against a Bear Market

Today, we are going to present some new information based on hedging in a bear market that is based on the prognosis that I made on two of my recent blogs entitled “Are we in a Bubble?” and “How low can it go?”

The ‘Are we in a Bubble?’ blog was asking the question, “are the stock market and the real estate market are in a bubble”. I would encourage you to take a read of it because it presents some conditions that are present in every bubble top. Now you will notice on the blog that those conditions are in fact with us right now, my conclusion on the blog was that yes, we are in a bubble. So, by Jiminy doesn’t mean sell everything?

Probably not, and, let me explain why. Just because we’re in a bubble, doesn’t mean that we’re at the top of that bubble. We don’t know when it is going to end. For example, back in 1998. 1998, 1999, I was with Merrill Lynch, and Don Kapetanakis was the NASDAQ technical analyst at the time. He was looking at chart angles, sentiment indicators, and things like that. And he presented a detailed paper on why he thought that the market, the NASDAQ in particular, was going to be just slammed. He felt that it was in a hyper bubble. This would have been around 1999. I think he presented that well, if anybody looks at the charts, they’ll see that the damages during the technology sell-off and the NASDAQ crash were largely done in late 2000, 2001.

So, Don was right. The market was in a bubble in 1999 when he made that statement, and he wrote a detailed analysis paper on it. But the market went up, the NASDAQ went up, about another 20-odd percent, maybe 25%, 30% after he wrote the paper.

I remember he received an awful lot of criticism during the years of 1999 and early 2000 because the market, the NASDAQ just kept going up. And so ultimately, if you had sold, when he said to sell, you would have missed out on 25% gain, but you then would have also missed out on a 55%, I think it was, drop on the NASDAQ. Net-net you would have saved yourself about 25-30%, but at the time, of course, when people followed his advice and watched the market go up another 25% or so, they weren’t happy with Don.

This taught me something. And that was that you can be right about the position the market is in, the stage, the setup that we’re in, but your timing isn’t necessarily going to be right by some of the traditional stuff that he was using such as chart angles and sentiment, which are things I use.

Let’s fast forward to the mid two thousands 2006, 2007, 2008, 2009. If you were to look at the markets back then, there were many signs that we were in a bubble. One of the areas that we were extremely focused on back, then beyond the subprime mortgages and the banking sector, was oil. And I remember there was a lot of talk. A lot of books written like “Your World is About to Get a Whole Lot Smaller” and, peak oil theory was the banter was all about. The indication was that with worldwide growth, oil was going to be used in greater quantities as more and more people in developing nations, drove cars, opened factories, all that stuff.

Oil prices were going to go up and they did in fact go up. But the calls were for oil to hit $200 a barrel in short order. And I remember in around 2007 or so because of the technical work that I do on sentiment, I started selling oil stocks when oil hit around $90 a barrel.

Now I was right. I was identifying a bubble because, if you follow history, oil did fall by the summer of ’08 to $30-odd it was around $35, $36 a barrel in ’08. I started selling in late ’07 at $90 a barrel.

I was right, but here’s the problem.

In between ’07 and ‘08 oil went to $140 odd dollars a barrel. I got a call from a client in early ’08 and he said, “I’m leaving you”. And I’m like, “What?” You know, I don’t usually lose clients. And I said, “why?” And he said, “because you missed the boat on oil”. And by this point, I think oil was trading at around $120, and I had sold it at around $90. And I said, “oil is overbought I think it’s going to you know, my sentiment indicators, et cetera, saying, it’s going to sell off.” Well in the end this guy transferred out and he ended up buying oil with his new advisor. I was a portfolio manager. And what happened was, is that oil went up a little bit more and peaked in the spring and fell like a rock as all know.

Again, lesson learned. My indicator said the conditions were there for a bubble on oil, but the conditions were not breaking down from a technical perspective. So, one of the lessons that I learned back then was don’t sell before the trend bridge. Now, luckily, I did start selling stocks during the ’08 crash early and anybody that looks at my investment history can see that I did quite well in ’08 because we were one of the few portfolio managers that were selling out as the peak and trough got lower. But oil was one of those things that I got out of early, too early.

Today’s video is about hedging against the next bear market, but I’m going to caution you that you do not start to sell until the market rounds over breaks is 200-day moving average and starts making lower lows and lower highs on the weekly chart. That’s my caveat before getting into hedging against a bear market.

This is a shot of an indicator that I don’t use in my Bear-o-meter, but it is very worth looking at, and it is the American Association of Investors, number of bears out of their survey that they do on a regular basis. This is the percentage of bears, and they’re a big, very good organization of retail investors, which is often called dumb money (less informed than the institutional investors).

When you have a high reading of bears that usually indicates a bottoming market, and you can see early 2020 in the COVID crash, there were a lot of bears. They were selling at the wrong time. They were bearish at the wrong time. When you have a market high before the COVID crash there are too few bears.

You can see in December the crash of December of 2018, there were too many bears because everybody was concerned. Everybody thought the world was ending and, that that was actually a good time to buy and so on.

So where are we right now?

We are looking at a recent reading of around 20% of their survey. People are bears versus 80% were bullish. It’s up to 24% right now, are bears, but it’s still a bit greater majority.  There’s not a lot of bulls in that organization. This can be a sign of a short-term top, although not necessarily the big bubble, just like I was just speaking about.

I’m going to look at a few hedges though, that what if it were the top?

I want to look at a couple of things, and this is not to endorse any of these investment vehicles, but this is the chart of the S&P 500, which is in red. And the GE, which is the Rangers short hedge ETF. And all they do is they take the S&P 500 and they short, I think it’s around 40 50 names. You can look up their perspectives. They short what they feel is the worst quality names out there. And you can see that it’s negatively correlated when the S&P is going up. It goes down. But when the S&P goes down it goes up, so you can see at the bottom, this is a correlation chart. You see the closer to the negative one, which is down way down here, the more perfect a hedge it is.

If you really do see the signs of a bear market, you can look at putting part of your portfolio into a hedging vehicle like this. The problem is, is that when the market starts going up again, and as you can see, you can immediately start losing money on these things again. So, you must be quick with your activity.

I’ll bring you to a similar instrument, which is a common instrument. And this is basically a perfect hedge. You’ll notice that there were ripples in the correlation line on the HDGE that we just looked at with the inverse ETFs. Now, this is a single inverse, and that means that there is not leveraged. It’s not a perfect, perfect hedge, but you can see its 0.99% negative correlation, meaning pretty much perfect. Pretty close. Basically, if the market’s going down this thing goes up in a perfect non-correlated way.

Market going up, this thing goes down. So again, it’s an inverse in the name itself explanatory. It does the opposite of the market. So, you’d better be prepared to get out of these things. If you do call the market a bear market correctly, you better be prepared to get out when that bear market ends, because if the market starts going up, you can lose your shirt on an inverse very quickly. Never ever use any kind of a hedging investment unless the market is showing technical signs of going down. You don’t just guess ahead of time that you should hedge.

I’m a big believer in trend following. If the trend is negative, you could do something like this. At ValueTrend we don’t do a lot of this kind of stuff, but we have on rare occasions bought single inverse for 5% and 10% of the portfolio. I never recommended all short or hedge positions. It’s just playing with fire.

Now, for those who don’t want to be that aggressive, this is a chart I showed last week. And what I pointed out is that when the S&P which in this case is the black line goes down. You can sometimes get on the dividend stocks a bit of non-correlation. Here we saw that the dividend stocks were heading down, but the S&P basically didn’t head down as much. So, it’s going to be kind of negative at times, but then when the S&P was going up, the dividend stocks fell hard. So, it is a less correlated asset class, if you buy high dividend payers if the market is beginning to round over a bit. This is not the perfect solution to hedging a portfolio, but it’s probably a safer bet than trying to time it with the inverse of the HDGE that I just showed you.

However, if you feel that your analysis is fairly good, as far as picking when the trend is ending, and when the trend is beginning for a down market, then you can consider using an inverse or shorting type of investment. Just be aware that it’s a double-edged sword because if it goes opposite on you, you can lose money in a hurry because the market does like to rally hard after any kind of a bear market move. You better usually sell early rather than wait for every last nickel if you are hedging. Personally, the way I hedge is I only use a small portion of the portfolio to buy an inverse or that type of investment to offset some of the risks on the rest of the portfolio. The way I look at it is even if I’m wrong, I’m just neutralizing against some of the other stuff that will be going up.

Let’s say if I’m wrong and the hedge goes down, I’ve created a neutral environment, but it’s not an outright bet. So that’s usually the way I suggest looking at hedging within a portfolio, never go all in or you will get your fingers burned.

Thanks for watching. And again, I hope this video helped. It’s just food for thought if nothing else. This is not a recommendation, particularly this time to get involved with hedging strategies, because I do think the market’s got, you know, just a small correction ahead of us, but when that time comes, it’s a good thing to have in your quiver of arrows.


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