Protecting An Industrial Portfolio: Market Timing Or Hedging?

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 |  Includes: CSX, DAL, DE, JOY, LLL, LMT, NOC, NSC, RTN, SH, SWK
by: Fred Piard

For a specific stock portfolio, the choice of going to cash, hedging, or doing nothing when a bearish market signal is triggered depends on various factors. Among them, sectors and industries. For a Consumer Staples portfolio, timed hedging appears to be the best solution for investors focusing on total return or risk-adjusted performance, but just holding without protection may be better when the focus is on a lower volatility or drawdown (article here). Consumer Staples has two characteristics that make it a defensive sector in market downturns: products are less sensitive to the economy outlook, and companies are paying an average dividend yield above the mean. This second article of a series will look for an answer to the same question in a cyclical sector: Industrial.

Once again, I will use an extract of a personal research on the relations between sectors, market capitalization segments, a set of 25 fundamental factors, and stock prices. For each sector, I defined a ranking process. The S&P 500 Industrial ranking process is very simple and uses only one fundamental ratio, but cannot be unveiled here. The aim is to measure the impact of protection tactics on a reference portfolio. My purpose is not an optimal strategy, but something based on common sense and fundamental data to model a portfolio of "good companies" in this sector. For the next part, I will use a strategy consisting of a 4-week rotation of the ten S&P 500 stocks of highest rank in the Industrial sector.

I have performed three 15-year simulations (1/1/1999-11/29/2013): without protection ("NP"), with market timing ("MT") and timed hedged ("TH"). The portfolio is rebalanced every four weeks. The timing indicator is the same for market timing and timed hedging. It is defined by a bearish signal when the S&P 500 current year EPS estimate falls below its own value three months ago, and a bullish signal when it rises above this value. This is an aggregate fundamental indicator. There is no technical analysis here. The hedge is an S&P 500 short position in a 1:1 ratio with the portfolio value (for example buying SH).

The next table shows simulation results. Dividends are included, transaction costs are 0.1%. A 2% annualized carry cost is applied for temporary hedging positions.

S&P500 Strategies

Tot. Return

Ann.Ret.

Drawdown

Volatility

Sortino

Correl./bench.

Industry-10best-NP

774%

15.7%

-69.4%

29%

0.53

0.81

Industry-10best-MT

756%

15.5%

-27.5%

17.2%

0.78

0.50

Industry-10best-TH

1779%

21.8%

-31.3%

21.9%

1.22

0.41

Click to enlarge

Unlike Consumer Staples, an unprotected Industrial portfolio incurs a risk of very deep drawdown and is not an acceptable solution.

The timed hedging gives the best total return and the best risk-adjusted performance (Sortino ratio).

However, a classic market timing (going to cash) shows a lower risk measured by volatility or drawdown.

Here is the equity curve of the strategy with timed hedging (in red) compared with the S&P 500 index (in blue):

Click to enlarge

This is a dynamic portfolio. On average, 1.5 stock changes every four weeks. An analysis of current holdings is out of scope here, but listing them is necessary to make the example realistic:

CSX Corp. (NASDAQ:CSX), Delta Air Lines Inc. (NYSE:DAL), Deere & Co. (NYSE:DE), Joy Global Inc. (NYSE:JOY), L-3 Communications Holdings (NYSE:LLL), Lockheed Martin Corp. (NYSE:LMT), Northrop Grumman Corp. (NYSE:NOC), Norfolk Southern Corp. (NYSE:NSC), Raytheon Co. (NYSE:RTN), Stanley Black & Decker Inc. (NYSE:SWK). The highest weights by industry are currently in Aerospace & Defense and Machinery.

The conclusion is that a protection tactic is necessary in this sector to avoid heavy losses in market downturns. Timed hedging may bring a better performance and a lower correlation with the benchmark. Market timing may bring a lower risk. My next article will evaluate the same protection tactics in another sector. Click on "Follow" if you don't want to miss it. Links to additional information sources can be found in my Seeking Alpha profile.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Past performance, real or simulated, is not a guarantee for the future.