The Importance of Hedging Against Bad Earnings

 |  About: SPDR S&P 500 Trust ETF (SPY)
by: Marc Gerstein

GDP, General Motors (NYSE:GM), AIG, Employment data, Home construction, etc. Commentators are never at a loss for coming up with a variety of explanations for what the market does. But to me, it looks like it still boils down to earnings. And right now, that's still a very iffy thing. So besides just guessing, perhaps it would help to use a simple, easy to implement, hedge.

Here's a quote from Yahoo! Finance article on April 7, 2009 that tries to explain the -2% (so far) drop in the major indexes:

Wall Street extended its losses into a second day Tuesday as worries about banks' balance sheets and poor first-quarter earnings reports intensified.

It's always about earnings. Marco Salerno, founder and C.E.O. of has been looking at the daily trend of the SP500 trailing estimates and came up with some interesting observations. Looking at the past 12 month aggregate EPS helps him remove all the noise: news, bail-out announcements, predictions, etc, etc.

Figure 1 is a 5-month daily graph. The SP500 EPS is in red, the SP500 index in blue, and the Risk Premium in black. Ignore the Risk Premium from these observations because it's based on future earnings.

Figure 1

There are three key observations from Figure 1:

  1. The trailing EPS started rising after a steady downtrend and the SP500 seemed to have found the bottom in a range between 800-900.
  2. The EPS started falling again and shortly after, the vertical line, the SP500 followed suit, hitting a low around 676 from about 868. That's over -20%!
  3. The EPS downtrend stopped and went flat for a few weeks. This encouraged buyers that the bottom was in place and the SP500 went from 676 to about 840, a gain of +20%!

Figure 2 is a close-up of the 2 month daily SP500 EPS graph. The goal here is to determine if the recent rally is real.

Figure 2

Salerno makes the following observations:

  1. The EPS going flat encouraged investors that the worst was over and the market rallied 20+%
  2. Bad 1Q earnings are starting to come in and the EPS started trending down again. This seems to signal a top for the current rally.

These are very simple observations based entirely on the past earnings. But as we all know the market is always looking forward looking, so what good can this be? Salerno’s response:

First of all, I'm long several positions that I don't touch unless they are normally rebalanced by the model I’m using. I use the EPS trend to decide when to hedge my longs with an SP500 short position, like UltraShort SP500 (NYSEARCA:SDS). When I place the hedge I do it on margin, usually 30-40% of my portfolio, but it's a safe bet. If the market goes up my longs offset the loss in the SDS, and I break-even. If the market drops, I protect the recent gains. After losing 40% on my longs I can no longer stomach losses, so I'm willing to give up some gains from rallies because at this moment I am not convinced they are real.

The verdict? Every time I placed a hedge I made money. I'm not greedy though. I usually enter the hedge a bit late and exit the hedge too soon, so I'm only partially offsetting my gains. But when I do it I avoid a 2 to 4% loss, which in time adds up.