The Present Risk/Reward Setup Demands Action

While typically the third year of a first-term presidency is one where we’d expect market-friendly political forces to provide a tailwind for stock prices, in this age of populism and protectionism we’re seeing precisely the opposite. 

Rather than promising the likes of infrastructure programs and, say, increased 401(k) limits, not to mention trade deals, both camps see playing to voters' fears, and sense of victimhood at the hands of foreigners (and/or of the establishment itself) who aim to steal our technology, our jobs, and, at the extreme, our American way of life, as producing the biggest bang for the campaign buck.

This makes for a very messy market going forward. On a day-to-day basis, trade war headlines and the Fed (and economic data that would influence the Fed) are moving markets in a big way.

As for the trade war, as I type, it’s the worst it’s been (could it be the dark before the dawn??). Trump has signaled that he’s in no hurry whatsoever to do a deal, and China has hunkered down to the point where they’re weaponizing their media (i.e., their consumer), and, some believe, their currency.

Beyond the U.S. and China, there’s China and Hong Kong, and there’s the UK and the EU. As for the latter, new UK PM Boris Johnson is playing to his populism-inspired popularity and promising that come 10/31 the UK becomes unshackled from the EU, with or without a trade deal. A no-deal Brexit will prove initially devastating for global markets.

All present indications are that the status quo – the perceived political expediency of protectionism – will remain well into 2020, with the Fed having to cut rates twice more this year in an effort to stave off recessionary trends that are directly caused by present global uncertainty, supply chain disruptions, etc.; i.e., the trade war.

At worst, China retaliates further, and the White House increases the latest tariffs from 10% to 25%. In such a scenario the ensuing correction in stock prices will be severe enough to rein in the consumer and quite possibly precipitate the next recession (imagine adding a no-deal Brexit to that scenario!). At which point a trade deal will be patched together and quickly struck; whether or not that would be enough to reverse the then recessionary forces remains to be seen. 

While I’m not often on the same page with economist Larry Summers, he’s got it completely right this go-round:

(Bloomberg) --

“The U.S. and world economies are at their riskiest moment since the global financial crisis a decade ago as trade tensions continue to grow.”

An alternative, far rosier, scenario, is one where Trump and Xi make nice, and make a trade deal (and Trump doesn’t incite tariff wars with other trading partners), where the UK and the EU make nice, and make a trade deal, and where China leaves Hong Kong the hell alone and allows them to govern themselves as they see fit. Parts one and two are at least possible (part 3’s not), and, by themselves (part one in particular), could very well place the economy and the markets on a different, far more productive, path than the dead-end one they’re currently on. 

While the alternative “far rosier” scenario may indeed play out (it’s completely a matter of political calculus at this point), given the present risk/reward setup (and I didn’t even get into the technicals this morning [which aren’t great]), this is absolutely a time to guard against the potential for what might otherwise be a healthy correction morphing into an all-out ugly bear market -- while of course sacrificing a decent chunk of potential upside in the process.

In other words, and to pound it home!, the risk of a major, protracted downturn in stocks is greater today than it has been since the last major, protracted downturn in stocks. Doesn’t mean it’s going to happen, but it absolutely demands that we begin preparing just in case!

Investors who right here address the risk by repositioning assets to an all-out defensive posture (sell cyclical stocks and move to cash, bonds, gold, defensive equities, etc.) stand the chance of a substantial whipsaw (stocks leaving them behind) should the powers-that-be realize sooner than later that ultimately protectionism (an economy killer) is not in their political best interest, and make nice on the trade front. 

Our present strategy:

While a modified options collar (our chosen strategy) establishes a floor for a portfolio (relative to moves in the S&P 500), it too will suffer the effects of the whipsaw scenario: The difference being that the upside limit comes by way of a period of flat performance, after which gains resume, versus the all-out sacrifice of gains – and/or the palpable uncertainty (and huge risk!) of trying to jump back into what virtually has to be a late-stage resumption of the longest bull market in history – in a typical repositioning scenario.

The graph below is for a ~one-million dollar account (with 83% exposure to stocks) that we hedged a couple weeks ago (2918.65 is where the S&P 500 closed on Friday). 

The yellow line tracks the path of returns at various S&P 500 levels on expiration of the collar (Jan 17th of next year), the red arrow points to the period of upside where performance flattens. 

Assuming the portfolio moves as it has historically in relation to the S&P 500, the upside flattening amounts to approximately $60,000 of lost gains should the market move more than roughly 12% higher from here (note: the market’s down since we put on the hedge, and, thus, their collar [presently impacted by time value to expiration and the price of implied volatility (factors that only move options prices prior to expiration)] by itself presently shows a gain). The flattening stops at roughly +10% from the level where we implemented the collar. 

The downside limit (same correlation assumption) -- at expiration -- is approximately -$40k, regardless of whether the S&P 500 is down 10% (which would amount to a -$80k+ hit were this portfolio not hedged) or a 2008-style down 50% (would be a -$400k+ hit, un-hedged) come expiration. 




Attention Clients: If the term "options collar" is new to you, you've been missing in action. In which case watch this video, then this video, then shoot me an email and we'll send you some paperwork.