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The volatility of price action since the first of the year is highly indicative of a market top. Those who suggest we won't see a significant correction this year - and we haven't seen one yet - have been desensitized to market corrections stemming from very proactive fiscal and monetary policy and unprecedented attempts to manipulate market price in virtually all asset classes.

There are two primary arguments for why stocks will move higher in 2014. One - the economy improves and corporate profits continue to climb and, two - as emerging market economies implode money will flow into US companies as it has no place else to go.

The first argument seems improbable in that we aren't likely to see an improving economy in 2014 for reasons that should be apparent to most and we will discuss a few of those in a moment. The second argument is one that Martin Armstrong continues to support. Here is an excerpt from an interview with Armstrong that sets forth the argument for higher stocks based on money flows:

Jim Puplava: Martin, there are many out there saying that we are either at or near a major top in the stock market and also warning of a catastrophic collapse. Do you agree with that sentiment?

Martin: If you just look back at all the major highs-1929, gold in 1980, any of the commodities; take a look at any chart-major highs are always associated with what are referred to as "spike highs". We don't have that in the stock market. And again, most of the analysis that people are hearing is largely from people that are focused only on the U.S. They are blind to what is happening globally, and it's just an international economy…so, largely, the stock market has been pressing up because you have serious trouble out in Europe-it's an absolute basket-case over there-and capital has been moving out. You have interest rates that have been so low, you have pension funds that are virtually on the brink of insolvency. And it's been forcing them to go into equities where they're at least earning 5-7% dividends. And essentially you have China starting to turn down; you have Japan where capital is starting to move out and go into South East Asia and creep back over here. So the stock market has actually been well supported. I mean there will be a correction here short-term, but [the market] has been crawling up toward major resistance, which is at 16,000, and we've not been able to get through. We should back off first and then, I'd say, we're going to go back up and make major highs in this thing going into late 2015, to the point where the Dow may even double in value yet.

If I understand Armstrong's point, he thinks the US stock market could actually double in value in the next two years based on the idea that every other part of the world is worse off than we are meaning money will flow to US stocks. My question is this - what exactly is a US stock? Would it be Apple (NASDAQ:AAPL), GM (NYSE:GM), Ford (NYSE:F), IBM (NYSE:IBM), Boeing (NYSE:BA), Microsoft (NASDAQ:MSFT) - well you get the idea I hope but if not the point is there aren't very many US stocks today.

The truth is we have a global economy and almost every major company defines its target market as global and that means a downturn in the euro zone or China or any other country or region has an impact on that company's earnings. If I decide that it makes sense to buy Apple stock for instance as I am really worried about the demand for iPhones in Europe or Asia am I making a logical decision?

The point is this - there is no safe haven in a global economic downturn. What moves stock price is the bid and ask for a specific stock and when the ask is the driver stocks fall and when the bid is the driver stocks rise. Martin Armstrong's a pretty smart guy so I don't mean to suggest he isn't thinking clearly on this matter but the facts suggest that a portion of the wealth that has been created since the 2009 low in stocks can just as easily disappear in an economic downturn.

Armstrong sees the Dow potentially doubling in 2 years but also sees Europe as "an absolute basket case" and "China starting to turn down". My simplistic logic suggests that if Armstrong is right on these points then he is wrong on the call for a higher Dow over the next two years.

Make of that what you will but for my money Armstrong is wrong. Now to the next argument for why stocks might go higher - improvement in economic growth. I promised to take a look at some data to see what the prospects are for a sudden surge in economic growth going forward so we will do that.

We will start with GDP growth - a metric that was reinvented last summer to include intangibles - to see how that looks. The chart below is interesting in that both lines are the exact same metric. The only difference is the way in which they are presented. The blue line shows percent change in growth based on the annual rate of change and the yellow line shows the rate of growth based on a quarterly rate of change.

The headline number reported for the 4th quarter of 2013 was 3.2% - the value reflected by the blue line in the chart above. The trajectory of both numbers is down but it is hard to argue that the headline number chosen was the one that put the greatest positive spin on GDP. It's the one I would have chosen if I were trying to convince investors and consumers that all is well and we are still in growth mode.

Now let's look at personal consumption expenditures. Again the chart below plots the same metric and the only difference is the percent change with the yellow line reflecting the annual rate of change and the blue line reflecting the monthly rate of change.

Again the number looks a lot better reflected as an annual rate of change. In fact the difference is about 3% better. The point of course is that one can take the same set of data values and create a positive picture or a negative picture and I would suggest those who disseminate this data have a vested interest in making the data look as positive as possible.

Let's take a look at the employment picture. Employment is a major concern as far as growth is concerned going forward and the chart below takes a different look at the unemployment number than what you see in the media. The chart takes a very direct and straightforward look at the total numbers of people employed.

Certainly we have made some head way in this area but the truth is we still aren't even back to the pre-recession level on total employed and the improvement we have made has been expensive in that we have brought the debt to GDP ratio to a level in excess of 100%.

The chart below is the exact same metric expressed as monthly rate of change:

The following chart reflects total employees as a percent of the total population. It is not up to date as they discontinued this chart in January of 2011. I went ahead and did the calculation though so you can see what has happened to this metric since 2011 - it is reflected by the red line and shows that we have fallen to 43%.

I just don't see much progress in the unemployment situation as it is much worse today than pre-recession and about the only way you can see this metric in a different light is to look at the BLS's headline unemployment chart:

We all know how this metric is reflected in a positive light - it is done with what I call the propaganda variable - the Labor Force Participation Rate. As the participation rate continues to fall the unemployment rate continues to fall as the unemployment rate merely measures those employed relative to those who remain in the labor force. Here's the chart for those who care to look:

So if one were to accept the idea that the prospects for improved growth in 2014 don't look too bright then what does that really mean? After all stocks have been climbing steadily and so have profits - right? Well let's take a look at the S&P 500 to see what has fueled the rally in stocks.

The facts are stocks have been climbing due to multiple expansion since September of 2011 when the S&P 500 PE ratio bottomed out at 13.50. The following chart shows the S&P 500 as reported 12-month trailing earnings PE ratio courtesy of www.multpl.com:

(click to enlarge)

Here is a look at the S&P 500 earnings growth chart that confirms stock price appreciation has been based substantially on multiple expansion for almost 2 years now:

(click to enlarge)

The mean value for the PE ratio reflected above is 15.51. Looking at the chart one can conclude that stock PE ratios are well above mean but nowhere near historical highs. Assuming earnings don't show growth in 2014 then any further gains in stock price would require an additional increase in the PE ratio. If earnings remain flat and the S&P 500 moves higher by another 10% in 2014 the PE ratio would be 21.17 - still well under the historical high so it is not impossible to see further gains in 2014.

On the other hand even the bulls seem resolved to the idea that we are due a correction of at least 10%. A correction of 10% from current levels would put the S&P 500 at 1647 and a pull back to the mean value would put the market at 1474. The chart below shows the S&P 500 with the 10% correction reflected by the upper red line and a pull back to the PE mean value assuming flat earnings reflected by the lower red line:

(click to enlarge)

I suppose one could argue that the market has defied gravity for the last few years and may continue to do so for another year. That could happen I suppose but for those with a less optimistic perspective the rest of this article delves into the matter of protecting and increasing the gains achieved since the post-recession low even if we move into a cyclical bear market.

Hedge strategy

A good hedge strategy should protect one's portfolio from loss by making as much in a bear market on the hedge trade as one loses on the portfolio positions. There are a number of strategies that one could employ but the list below seems more than adequate for our consideration:

  • Buy at the money puts
  • Sell covered calls
  • Buy volatility

I don't like the idea of buying options as a rule in that the time value premium ends up eroding the value of the option and the option ends up expiring worthless if the market remains flat or moves against the trade. That of course is dependent on how deep in the money the option is but I much prefer writing a covered call in that one pockets the full value of the time value premium. We will discuss both but first let's look at volatility. The chart below reflects UVXY (NYSEARCA:UVXY) and SVXY (NYSEARCA:SVXY):

(click to enlarge)

I have been buying UVXY calls for about 12 months and can attest to the fact that leveraged volatility plays don't work out to well when you are on the wrong side of the play. The reason I have played it this way is that I have been expecting a major selloff in stocks but that hasn't occurred yet so the result - I've lost money on my volatility play.

The fact is I have been chastised by many of my readers who insist on explaining to me that leveraged volatility is a bad play and that UVXY has lost virtually 100% of its value over a fairly short time period. The chart above attests to the truth of that fact as UVXY really has lost almost 100% of its value.

The reason doesn't have to do so much with contango or the fact that it is a leveraged play as it does with the fact that I have been on the wrong side of the play. That is the reason I plotted the inverse of UVXY to show you what being on the right side of volatility can do for you. The chart above shows that SVXY - the opposite side of UVXY - has actually appreciated in value by as much as 300% while UVXY has lost 100%.

In other words if one had invested $1000 in UVXY and $1000 in SVXY 2 years ago he would have lost the $1000 he invested in UVXY and the $1000 invested in SVXY would have appreciated in value to roughly $4,200 at its recent peak. That works out to a gain of $2,200 on an investment of $2,000. Had one just bought SVXY calls he would have seen an increase in value from the original $1,000 to $4,200.

There is no way I know of for correlating UVXY specifically to the S&P 500 in a way that assures losses on portfolio positions and gains on volatility would offset perfectly but my guess is that an investment in dollar terms of roughly 10% of one's portfolio value would be a reasonable guesstimate on what would be required to achieve that goal.

The chart below is just one month and shows that when the S&P 500 fell by 6% UVXY spiked higher by 64%. However, when the S&P 500 reversed course and pushed back toward the highs reflecting a one month loss of only .49%, the UVXY gain dropped to only 3.82:

(click to enlarge)

At the peak the UVXY gain was 12.25 times the S&P loss but after the S&P rallied back toward the highs the UVXY gain fell to just 7.80 times the S&P loss. It is that up and down but going nowhere kind of price action that will slowly erode the value of UVXY.

Make no mistake on this point - in a sideways or up market you will lose value in a play on UVXY. On the other hand if we do see a correction of 10% or 20% during the first half of the year it seems reasonable that UVXY positions allocated at approximately 10% of one's portfolio value would offset one's portfolio losses and could actually result in a net profit if the descent occurs quickly.

Portfolio allocation considerations

One other consideration is the allocation of one's portfolio in the first place. If the portfolio has high PE stocks that have benefited mightily in the last few months the magnitude of the loss in a correction could be much greater than the S&P 500 requiring a much larger cash commitment to the hedge.

Here is an example of just such a stock. Priceline (NASDAQ:PCLN) is up 4 times more than the S&P over the last year. It is one of my short plays that I have made as a pure speculative play. It is nothing more than a multiple play in that I anticipate a significant fall in price to more reasonable PE multiples in a market correction:

(click to enlarge)

The trailing 12-month PE is currently at 34 and it seems reasonable that a 20% correction in stocks would result in much of the 80% gain going away. If just half the gains were lost Priceline would fall to roughly $765. At the time of this writing a $1200 strike price July put is currently priced at $66 and would be worth $535 if Priceline did fall to $765 - a gain of $469 on an investment of $66.

Another stock that is selling at very high multiples is Facebook. Here is a look at that chart:

(click to enlarge)

Facebook's trailing 12-month PE is 110 - another example of euphoric giddiness in my opinion and one wonders what happens to this stock with a 20% market correction. A June $65 put (again at the time of this writing) on this stock is $5.50 and it doesn't seem out of the realm of reasonable that the stock could lose 30% easily and that would put Facebook at approximately $47. In my opinion I am being generous here as a 20% drop in the S&P would likely produce a much steeper drop but even the 30% takes the $5.50 put to $18.

A stock that has a lot of similarities with Facebook is Netflix (NASDAQ:NFLX):

(click to enlarge)

Netflix has a trailing 12-month PE of 235. A cursory look at Netflix Income Statement leaves one a little puzzled as to why this stock would be up by almost 7 times the S&P 500 gains in 2013.

Revenues for 2011, 2012 and 2013 are $3,204,577, $3,609,282, and $4,374,562 respectively with all values presented in thousands. Net income from operations for the same periods are $226,126, $17,152 and $87,274 respectively - again with all numbers reflected in thousands.

Apparently those bidding Netflix up looked at 2013 earnings relative to 2012 - a 5-fold increase - and simply ignored the comparison of 2013 earnings to 2011 earnings - a 61% decrease.

My purpose here is not to provide an in-depth analysis of Netflix or any of these high PE stocks but rather to suggest that these high flyers are not rationally priced and reflect major multiple expansion that has - in all likelihood - moved well ahead of the curve and present real dangers in a market that goes into correction mode.

Falling in love with these high flyers can prove costly and there is no better example of that than everybody's darling back in 2012 - Apple. I actually did call the crash in Apple back in 2012 suggesting it had gotten a little overheated and would sell off in coming months.

I made the call in September of 2012 and not because Apple was a bad company or that the company wouldn't fare well in the future - rather I made the call because I was convinced the stock had succumbed to irrational investor euphoria:

(click to enlarge)

For what it's worth I think the recent strength in Apple is based on the idea that the 2012 highs were reasonable and therefore the stock price today is undervaluing the company. I disagree with that assessment and suggest the 2012 highs were very unreasonable and perhaps Apple has once again succumbed to irrational investor euphoria.

There are a number of these high flyers with unreasonable PEs that are likely to suffer significantly in a 10% or 20% correction and a small allocation of money in puts moving out to at least 6 months on the expiration could be a good way to hedge a more reasonable portfolio allocation.

What would constitute a more reasonable allocation though? In my view those stocks that have underperformed the S&P 500, that have strong balance sheets, modest valuations on a comparative basis and good dividend yields fit into the more reasonable allocation category.

Microsoft for instance is currently trading at a 13.93 trailing 12-month PE with a 3% dividend yield. It has a price to book ratio of 3.67 versus a company like Priceline at 10.19:

(click to enlarge)

Or Chevron with a trailing 12-month PE of 10.23 and a dividend yield of 3.5%. Price to book on this stock is only 1.49. Here is the chart:

(click to enlarge)

Verizon (NYSE:VZ) is another stock that has underperformed the S&P and should fare better in a sharp correction. This stock has a trailing 12-month PE of 11.57 with a dividend yield of 4.50%. Here is the chart comparing the stock to the S&P:

(click to enlarge)

Keep in mind I am not suggesting these stocks will appreciate in value in a broad market selloff but I am suggesting they won't fall as dramatically in a significant broad market selloff. For those who must be invested on the long side of equities allocating one's portfolio in stocks that have appreciated but significantly underperformed in the recovery are decidedly better choices than those stocks who have appreciated dramatically since the end of the recession.

Equally important is the dividends these stocks are paying which can go a long way in mitigating the consequence of a broad market selloff. That said, it still makes sense to take protection in these stocks as I would still expect them to sell off in a broad market correction.

Perhaps the best way to do this is to write covered calls on these stocks. As of Friday's close the ask price for the VZ March 35 call was $12.50. The closing price for the stock was $47.23 leaving a modest 23 cent time value premium. The point though is to go net neutral on price in anticipation of a significant selloff in the broad market.

Assuming the stock does sell off by 10% the covered call would gain in value by an amount equal to the loss in value on the stock resulting in a net neutral position on the stock price plus one would collect the modest 23 cent time value premium. Additionally - and assuming the company continued to pay dividends at the current level - one would accrue a dividend gain of roughly 17 cents for the one-month period. That is approximately 40 cents over the 1-month time period representing a one-month gain of .85% or an annualized gain of 10.15% before deducting the cost of trade on the option.

This strategy creates a net neutral position in the stock in that no gain or loss will be realized regardless of price movement. However, the dividend gain and the time value gain on the option will be realized regardless of price direction or the magnitude of the movement. Of course that assumes the company will continue to pay dividends at an amount equal to the current dividend.

The strategy is a little proactive in that each month one would need to write a new call on the stock with an expiration one month out to maintain the protection against downside risk and collect the time value premium for the following month. That said, it is at least reasonable to assume that one's portfolio gain would be in the 8% to 10% range over the course of the year and without the risk of substantial loss in the event of a major stock market correction.

A more aggressive version of the covered call approach would be to utilize margin and double the position size. On its face, increasing position size on long trades in a bear market doesn't make a lot of sense but remember that by writing covered calls one is really not long the market. In fact one is price neutral the market since what is lost on the long side trade is made back on the covered call position.

Additionally, using covered calls allows one to collect the time value premium of the call and the dividend generating a gain on the position. In the example above using Verizon the hypothetical gain over the course of one year would be 10.15% so if one were to double the position size with leverage the total gain would also double resulting in a hypothetical gain of 20.30%.

Playing the cyclical nature of the markets

The argument for a buy and hold long-term investment strategy is based on two facts. First, one cannot accurately time the peaks and troughs that define cyclical bull and bear markets and, second, the overall trend of the market is higher and therefore, even if one does lose money in the short term that condition will correct itself over time.

That of course is true but seems an incredibly passive approach to a matter of such great importance. In a recent blog post I made the following comments with reference to the long-term inflation adjusted Dow chart:

We've experienced 18 recessions since the creation of the Federal Reserve in 1913. That works out to one recession every 5.5 years on average - hardly what one would call a stellar success in terms of managing the economy. The chart below is the Fed's version of the inflation adjusted Dow dating back to the period just prior to the creation of the current Federal Reserve central bank system.

(click to enlarge)

Perhaps most significant is the period of time we have spent in a secular bear market if one defines a secular bear market as the period of time spent after an all time high in real terms before a new all time high in real terms occurs. Using that definition we have spent considerably more time in secular bear market territory than we have in secular bull market territory. The periods reflected inside the boxes are those sideways trends that constitute a secular bear market by the definition I am using.

Suffice it to say I am not a buy and hold kind of guy in that I know I can do much better over time with a strategy that is designed to exploit the cyclical nature of the markets. What is often misunderstood as it relates to my strategy is that many seem to think I put great stock in my ability to pick the absolute peaks and troughs with some degree of proficiency.

Although I don't necessarily believe I can do that I am pretty good at getting close a good percentage of the time. One example of that is my calls on gold over the course of the last two years. For those interested in my gold calls I would suggest a recent article I wrote on the matter of gold entitled Why A Gold Play Finally Makes Sense.

The point though isn't whether I - or anyone else - can predict with proficiency, the peaks and troughs of bull and bear markets. What's important is employing a strategy that will maximize gains relative to a buy and hold strategy over time. Over time in this context means one actually has more dollar gains at the trough of a market cycle than at the previous peak in that cycle.

It is still a matter of timing

Even though one can't predict with great precision when a bull or bear market will end one can at least predict when the market is getting overextended by simply using PE ratios. In the current situation much of the 2013 market gains were not based on increasing profits but on expansion of PE multiples. In fact that has been the case since the S&P 500 PE ratio bottomed in 2011.

Here is the point - it is almost impossible to predict the peaks and troughs of cyclical bull and bear markets with precision. That said, it does make sense to move slowly from bear to bull as markets sell off and from bull to bear as markets rally. It is - or at least should be - a process and not an all in kind of thing.

I became bullish in late 2008 - largely based on the decision that was made by policy makers to take a very aggressive fiscal and monetary policy approach to the recession. I was a little early but right in my call as stocks did finally bottom in early 2009 and start higher.

Playing the bull side of the market is much different than playing the bear side though. At the initial stages of a new cyclical bull market one needs to think in terms of moving to a fully invested position.

Keep in mind the trend is your friend and the long-term trend of the market is higher so that even if you miss the bottom as you are almost certain to do time will solve that problem for you.

Playing the bear side of the market is much more dangerous and should be approached with caution. The following chart reflects my own failure in calling a market top:

(click to enlarge)

I missed the call on a top by about 15% in that I expected the market to top out at no higher than the low 1600s on the S&P 500 and to date we have moved to roughly 1850. The 15% number on the miss assumes we are roughly in the neighborhood of the top at present but that is not a certainty by any means.

As noted I turned bearish in late 2012 and have played the bear side of the market now for about 15 months. But my strategy - which I have noted on numerous occasions in articles and comments - is taking highly leveraged positions with a small amount of portfolio cash and leaving the balance of the portfolio in cash or cash equivalents.

One cash equivalent would be long stocks while writing covered calls against those stocks which creates a net neutral situation on price but allows for the collection of time value premiums and dividends. In other words the strategy makes money in both up and down markets.

Taleb Nassim's barbell strategy

In researching a recent article I came across Taleb Nassim's barbell approach to investing which is precisely the strategy I have employed and the one I have advocated others employ for some time now. The following - in Taleb's words - explains what he refers to as the barbell approach to investing:

What do we mean by barbell? The barbell (a bar with weights on both ends that weight lifters use) is meant to illustrate the idea of a combination of extremes kept separate, with avoidance of the middle. In our context it is not necessarily symmetric: it is just composed of two extremes, with nothing in the center. One can also call it, more technically, a bimodal strategy, as it has two distinct modes rather than a single, central one.

I initially used the image of the barbell to describe a dual attitude of playing it safe in some areas (robust to negative Black Swans) and taking a lot of small risks in others (open to positive Black Swans), hence achieving antifragility. That is extreme risk aversion on one side and extreme risk loving on the other, rather than just the "medium" or the beastly "moderate" risk attitude that in fact is a sucker game (because medium risks can be subjected to huge measurement errors). But the barbell also results, because of its construction, in the reduction of downside risk-the elimination of the risk of ruin.

Let us use an example from vulgar finance, where it is easiest to explain, but misunderstood the most. If you put 90 percent of your funds in boring cash (assuming you are protected from inflation) or something called a "numeraire repository of value," and 10 percent in very risky, maximally risky, securities, you cannot possibly lose more than 10 percent, while you are exposed to massive upside. Someone with 100 percent in so-called "medium" risk securities has a risk of total ruin from the miscomputation of risks. This barbell technique remedies the problem that risks of rare events are incomputable and fragile to estimation error; here the financial barbell has a maximum known loss.

For the last 12 months now I have been sounding caution alarms and for the simple reason that we are not achieving anything that remotely resembles real economic growth and in fact absent record levels of deficit spending we would have remained in recession. My critics have been quick to point out that I left a lot on the table by going to cash - roughly 15% in fact at the present time based on my 2013 miss on a market high call in the low 1600s.

However, at some point we will top out and really begin a cyclical bear market. Granted, I don't really know when or where that might occur but in the full cycle play I get close enough.

I missed the absolute bottom in stocks back in 2009 by getting a little ahead of the curve. A rough estimate on where my average entry price was back in 2008 was in the area of 850 on the S&P. The absolute low was 667 so I was off by more than 20% in terms of calling the low. In other words had I made an all in bet on the S&P at those levels I would have lost 20% of my money at the worst point.

That said, I saw the crash as an opportunity where many saw it as catastrophe. I certainly couldn't have seen it that way had I allowed all my gains from the previous cyclical bull market to deteriorate though. Keep in mind I am a contrarian trader at market extremes and usually get in a little ahead of the curve as it is just my nature so I was bearish until late 2008. From late 2008 until September of 2012 I was bullish the market and turned bearish at roughly 1475 on the S&P. By bearish I mean that I went to cash - not that I aggressively shorted stocks.

Using the S&P only as a measure of my profits I realized a gain of roughly 53% of the move from trough to peak. I would have realized a net gain without compounding of roughly 156 S&P points per year or 18% per year on the average using my 850 entry price through 2012.

Keep in mind I didn't play the markets in 2008 by going all in on the long side nor did I play the markets in late 2012 by going all in on the short side. Rather I used a variation on my 90/10 strategy by gradually employing more and more cash to the long side as the bull market developed combined with very aggressive plays using a small percent of total cash in highly leveraged positions.

That said, the way I play the markets is not really the point and I wouldn't advise anyone to follow my lead as I am much more proactive than the average investor. What I would advise though is a strategy that gradually goes to cash or net neutral when PE multiple expansion and economic metrics suggest such an approach is prudent and to do the inverse when it appears markets have overreacted to the downside.

Just for the sake of argument let's consider my short call at roughly 1600 and assume I went net neutral on price at that level by starting a systematic process of writing covered calls. Let's say that I was nervous but still believed there was a lot of upside left in the market and made the decision to play very aggressively with 10% of my portfolio value as Taleb suggests. Let's also assume that the aggressive play involved playing SVXY.

Let's look at what SVXY did over that time frame:

(click to enlarge)

Assuming a total portfolio of $500,000 one would have been price neutral by writing covered calls at the start of the year and still realized a gain of maybe 10% on $400,000 of the portfolio from the dividend and time value premiums of the covered calls. That would have produced a gain in total portfolio value of $40,000.

Assuming the other $100,000 had been invested in SVXY at $38 and the trade was closed out at year end at $65, the additional gain of roughly $70,000 would have brought the total gain on the portfolio to $110,000 or 22% on the year. More important is the downside risk was fully mitigated under the assumption that the gains from dividends and time value premiums were 10% and also assuming a 100% loss of the SVXY position.

That's not quite as good as being long the S&P 500 gain of 28% but it is pretty close and there was - as a practical matter - almost no risk at any point under that strategy. Furthermore, one could have added leverage to the SVXY trades and actually out gained the S&P without increasing risk. In fact, one could have easily outperformed the S&P 500 by using leverage and doubling the position size in the $400,000 portion of the portfolio.

Summing it up

We've covered a lot here and it seems time to kind of sum it all up. Let's do so by looking at the best way to play the cycles - at least in my opinion - for the average investor.

Today we have reached a point where downside risk is at the extreme suggesting great caution is advisable as capital preservation should trump all other considerations. For those who are long-term buy and hold investors my suggestion would be to move to those types of stocks I mentioned above that have underperformed the broad market - stocks with strong balance sheets, high dividend payments and low PEs relatively speaking.

Additionally I would begin the process of writing covered calls against these stocks going one month out and with strike prices of 10% to 20% below current market. That essentially puts one net neutral on price movement but allows for the collection of dividends and time value premiums on the options. The more aggressive version of this strategy is to use leverage and double the position size allowing for the additional dividends and time value premium gains on the calls.

That is what I would do with 90% of a typical investor's portfolio. I would then use 10% of total portfolio value to leverage into high risk plays. My own choice would obviously be short-side plays but those who can't get the idea out of their head that a lot of upside is left in the market could leverage into long-side trades. Even if the trade is wrong 90% of the portfolio is protected and should earn money even in a bear market through dividend payments and time value premium profits.

I have covered a few of the short side plays above but let's review. Volatility would be a good short side play going with UVXY or VXX for instance. If you are set up to do so even more leverage could be achieved with call options on volatility on a portion of the 10% and for those with extreme risk appetites out of the money call options on UVXY.

I would not allocate the full 10% to buying options though as they are extremely risky plays. One can make huge gains on these plays when right but one also risks all the money invested in exchange for the opportunity.

Another way to play the short side with high risk, high leverage plays would be to buy puts on the high-flying stocks I mentioned above. I would go 6 months out on the expiration and might suggest out of the money puts for those really wanting to shoot for high returns. Again I wouldn't recommend putting all the 10% into out of the money puts.

Predicting the magnitude of the selloff

As hard as it is for long-term buy and hold bulls to resolve themselves to the idea that we really are in trouble today the fact remains we are and the issue is one of unsustainable debt levels. That is easily the single most significant metric that will drive markets going forward.

The reason I mention that is simply that one doesn't want to underestimate the magnitude of the selloff and lift hedges too early. I have discussed a selloff in the range of 10% to 20% but there are fundamental macro considerations that could push stocks much lower than 20% in the coming months. A look at the chart below seems useful as means for predicting the maximum downside risk:

(click to enlarge)

The chart pattern from 1965 to 1975 bears a striking similarity to the pattern we are currently in with the exception of the last bear leg down. If we were to repeat the pattern the downside risk for the S&P 500 projects all the way down to the mid-500 range.

Much of the current rally has been built on the back of leveraged carry trades and when leverage is employed to push the markets higher the consequence of unwinding those trades can have market impacts that take one's breath away. In other words the magnitude of the selloff can be dramatic and much of the time the move extends well beyond what is rational. For what it's worth the same irrational overshoot usually occurs at market peaks as well.

Keep in mind a 20% pull back is simply a correction in a cyclical bull market and not the start of a cyclical bear market. The question one must ask oneself is whether we will remain in a cyclical bull market for a few more years or will we begin a new secular bear market. If the answer to that question is the latter then the last thing one would want to do is assume he can pick the correction low with precision.

The goal here is to define a way for investors to stay invested but hedge those investments in a way that allows them to realize gain regardless of the direction of the market rather than give up all the gains realized over the course of the last 5 years. The 90/10 approach can do just that if properly implemented. Equally important - if we do move into a cyclical bear market those who have preserved and grown their portfolios through the bear market will be sitting in the cat bird seat in terms of positioning for the next cyclical bull market.

Source: Using The 90/10 Strategy For Protecting And Increasing Portfolio Value In A Bear Market

Additional disclosure: I also own puts on PCLN, AMZN, FB, NFLX