- Continuous heavy hedging through buying index puts has been very costly.
- Due to perception of the markets that someone will bail out their incorrect investment decisions, risk has been mispriced.
- Nevertheless, the tide of risk complacency is beginning to turn.
- Hedging through proper asset class diversification and keeping some cash to buy on major pullbacks is cheaper in the long run.
First, let me state that I am a great admirer of both John Hussman and Nassim Taleb. I am a regular reader of their analyses and have enjoyed several of Mr. Taleb's books. "Fooled by Randomness" and "The Black Swan" are excellent books that I've read several times, but my favorite book written by Mr. Taleb is "Antifragile: Things that Gain from Disorder." It is one of the most interesting books I've ever read.
The ideas of Mr. Hussman and Mr. Taleb are somewhat similar, as they put a great emphasis on hedging the downside risk in the stock market. In a nutshell, they either think that the markets are grossly overvalued or that the tail-risk is underappreciated, under-expected and undervalued by the general markets. Hence, according to them, it is profitable to outperform the market in the long run by buying tail-risk protection, notably in the form of far out-of-money put options on the S&P 500 index, its ETFs (NYSEARCA:SPY) and similar instruments.
In theory, this idea is very strong and on theoretical economic ground that I completely agree with it. However, when it comes to using this strategy of hedging tail risk, as is the case with Mr. Taleb's followers, or fully-hedging long positions with puts and hoping for an outsized general stock market drop with Hussman's funds (Hussman Strategic Growth Fund - HSGFX), it is bound to be a loser's game under the current economic reality since 2008.
As is the case with virtually every trading system or investing idea, once it is explored, it is usually arbitraged away. In the case of strategies of hedging tail risk, the situation is even worse because the governments worldwide have assumed the role of the insurer of last resort, lender of last resort and the rescuer of last resort in many aspects of life and economic reality. The trend, especially since 2008, has swung toward more government control. Some examples include the QEs and currency interventions done by the Fed, ECB, BOJ, BOE, the Swiss central bank and others. Negative budget balances year after year and ever-increasing total public debts mean on a global scale that higher and higher share of the world's GDP is produced by state-owned or state-controlled entities and mechanisms.
As an effect, market participants have become complacent, believing that someone will bail them out if their investment turns sour. The governments have essentially taken the position of a global re-insurer that provides all sorts of insurances in many forms for a wide variety of catastrophic events.
Is black swan insurance cheap or expensive?
Therefore, for market participants it makes no economic sense to buy long-tail insurance in the form of far-out-of-money puts on the stock indexes, because they bet that they will most probably get the same level of protection for free from someone saving their investment or not letting it fall further, as was the case in 2008.
In the post-2008 world, although the downside stock protection looks historically cheap (low VIX index in general), stock protection in the form of puts is actually overpriced, and not underpriced as Mr. Hussman's and Mr. Taleb's strategies imply. The tail-risk events will happen, for sure, but with lower magnitude than Mr. Hussman's and Mr. Taleb's models anticipate. This is why betting large corrections are a loser's game since 2008. Since 2008, a large market decline is less likely than under natural market scenario.
Fully-hedged position underperforms during a long-term, steady bull market
Being fully hedged - Mr. Hussman's position -- means the net long position is zero. I can get the same position by having the money in a bank in CDs, getting at least some interest and saving on the fund's management fees, while probably even having lower counterparty risk and definitely lower volatility. The fully-hedged proposition simply makes no business sense to me in the long run. Mr. Hussman expects 2.2% annual stock market returns for the next decade, which I fully agree with, by the way. But by having a fully-hedged position and charging annual management fees, his funds are bound to underperform if his bet on meaningful corrections turns out to be false and the market just more or less grinds higher at 2.2% per year. If he is wrong, in the path the market choses, his funds will keep underperforming and actually losing money. They are already down roughly 40% since the 2008 peak.
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Image Source: Yahoo Finance
The tide is slowly turning
There are signs that risk is slowly returning to the system. The Fed started tapering. There are plans to redesign the level and system of support of U.S. mortgages. Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) investors were not pleased. The Chinese officials signaled they will allow more defaults but will make sure they prevent "systemic risk". New Zealand raised its key interest rate this week. It seems the tide is slowly turning in some regions of the world.
Wrapping it up
In conclusion, I am a great fan of Mr. Taleb's and Mr. Hussman's economic theories and findings. However, when it comes to applying their strategies in real-world investing, they have become victims of the popularity of their strategies and also victims of holding on to their opinion while the fundamental preconditions have been altered. I am not saying protection is not necessary and reliance on bailout is the right way to invest. Of course hedging is necessary in some form. But Hussman's and Taleb's strategies have been overpaying for insurance since 2009.
However, from a contrarian point of view, now is the perfect time to actually buy Mr. Hussman's fund, after it has been underperforming since 2009 after his hedging strategies experienced the worst and longest bear market, with the fund losing roughly 40% from its 2008 peak.
There are also better ways to mitigate risk and volatility. Instead of fully-hedging with puts, a more pragmatic long-term portfolio strategy for the post-2008 world is to diversify into various asset classes, such as stocks, treasuries, bonds, cash, commodities, gold real estate and perhaps others. Be pragmatic. Be net long the market. Invest for the long run and use accumulated cash opportunistically to buy on the dips. Don't overprotect with puts because it costs a lot in the long run.