What are the best tools for protecting against missing run away equity markets? People can disagree about the best timing and the best sizing, but here are three tools that are proving useful in 2013 thus far. Bullish? You might find these tools to be helpful and relevant today. Bearish? Here is what you might want to reach for if the market corrects and you want to use such a dip to jump back in. Whether you are looking to buy the all-time high or are waiting to buy the dip, here is what one might want to buy if you want to expose yourself in a hurry:
WisdomTree Japan Hedged Equity index is an exchange traded fund (ETF) that invests in dividend paying Japanese companies. In addition, it hedges out the yen's fluctuations against the US dollar. Global markets are increasingly correlated, but DXJ takes advantage of a less expensive equity market and more expensive currency in a single ETF. This has been my largest and favorite equity ETF so far this year. So far so good:
This is close to the perfect security: VXX is fundamentally flawed and XIV is the opposite. Velocity Shares Inverse Short-Term Volatility ETN (NASDAQ:XIV) is the inverse of the VXX ETF. VXX has been one of my favorite short ideas since the fourth quarter of 2011. Ipso facto, XIV is one of my favorite longs. VXX owns forward months one and two volatility futures and rolls some of this exposure each day. The negative roll yield is massive, averaging over 10% per month over the past few years. In short, VXX buys high and sells low as if that is its job… because for all intents and purposes, that is its job. What happens when a portfolio with a 100% roll yield turns over each month? This happens:
The XIV is the opposite - an ETN that is the inverse of the VXX, shorting forward month one and two volatility futures and rolling them forward on a daily basis. XIV buys low (month one) and sells high (month two) when the volatility futures market is in its typical upward sloping curve. Here is what has happened thus far:
Risk is always and everywhere a function of price, not volatility. However, there is a significant part of the market that is arbitrarily adverse to volatility because it is frequently used as a (quite flawed) proxy for risk analysis. Anyone who does not equate volatility with risk, but who recognizes that there are many counterparties that do, can be a service provider for such counterparties by owning XIV. Here is the XIV, versus VXX, with the SPY tossed in for a comparison:
Waaaaaay out of the money SPX calls
The S&P 500 is currently trading at about 1,800. If you go out a few years, you can buy calls on this index around 2,500 at attractive prices. How and why? First, "how?" A number of bank trading desks need to be nominally balanced between longs and shorts, but their portfolio managers have a much easier time finding long ideas. So, they frequently write way out of the money calls on broad indexes. These trades are often somewhat price-insensitive, pushing up liquidity and in bid-ask spreads on otherwise obscure contracts. The contracts are likely to expire worthless and give the desks latitude to pursue the specific long ideas that they wanted.
Why? If things go moderately badly, indifferently, or moderately well over the next few years, these contracts will expire worthless. Of course, in the off chance that things go extremely well, they may help one keep up with the Joneses (or at least with the Standards and the Poor's). However, there is another scenario in which these could be interesting. It could become increasingly clear that the Fed will never, ever enter rehab for its stimulus binge. QE could go on until the end. The end could be 1.) nigh and 2.) good for nominal equity prices. There could be a hyperinflationary death spiral and much of that hyperinflation could be in nominal equity prices. It is unclear that we would want to be in a world in which wages continue to plummet relative to equity prices, but that situation could dramatically accelerate from here. Many people could be utterly priced out of buying much equity with their wages. It could be the end of the American republic as we know it and there could be many terrible consequences. At the same time, the equity market prices could soar. We could have the rare situation in which prices rise as volatility rises - and both will dramatically raise the value of SPX calls.
Also, when you have a thesis on a stock (short AAPL, for an example), we look for ways to express that view that could have a better ratio of risk to reward (short ZAGG instead of AAPL). AAPL seemed overhyped as early as the middle of 2011, but we struggled to find a safe way to exploit that view for profit. Overhyped it may have been, but it also had a fine management, desirable products, and a reasonably-, if not low-, priced stock. Then we found ZAGG - a shady group of street hustlers hawking a commodity screen protector for AAPL products. Now there was a seedy and unnecessary product, expensive stock, and all with a faint whiff of impropriety about the management. While parents are stuffing stockings, ZAGG will be stuffing channels - sending their inventory to retailers along with promises to buy back the excess but booking the whole amount as earnings. If AAPL management ever determines that their corporate reputation is too valuable to be associated in any tangential way with such antics, then ZAGG will be in trouble. Meanwhile, the ZAGG short idea has already begun to pay off, especially relative to AAPL itself:
Zagging the Market
So if AAPL was in high demand, but ZAGG was a safer way to exploit a correlated negative view, what is the overall market's ZAGG? What is high when the market is high, but could be uglier on the way down? BID. Sotheby's (NYSE:BID) has had fortunes that rise and fall with the cadence of the equity market, but with far greater magnitude:
Asset price inflation inflates art and auction houses. If you believe that this is the top, you may want to consider shorting it. If you don't know if this is the top, you may want to consider watching it - doing so was instructive in '99, 07-08, and '11.
Disclosure: The author is long DXJ, XIV. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Chris DeMuth Jr is a portfolio manager at Rangeley Capital, a partnership that invests with a margin of safety by buying securities at deep discounts to their intrinsic value and unlocking that value through corporate events. In order to maximize total returns for our partners, we reserve the right to make investment decisions regarding any security without further notification except where such notification is required by law.