- The market is currently 45% overvalued, measured through five mean-reverting market valuation techniques that make economic sense, have a stable fundamental value and have predictive power.
- By giving up 3.4% of your upside, you can insure 87% of your portfolio value. Doing this in 2008 would have allowed you to outperform the S&P 500 by 37%.
- The current monetary policy environment is of great concern to investors, and should lead them to be increasingly cautious.
- In times of heightened risk due to QE and monetary policy, the threat of inflation is a valid concern in building an effective hedging strategy.
- The "Greenspan-Bernanke-Yellen" put gives investors a sense of false security in risk-taking.
Co-written by: Felix Boisse and Mike Jaksa.
In The Truman Show, unknown to Truman, he is living inside a TV show, where the producer plays God with Truman's life. The artificiality of today's markets, brought on by the "Greenspan-Bernanke-Yellen" put, is what Seth Klarman refers to as the "Truman Show" market. Investors require a hedging strategy to protect their portfolios from the storms created by these producers of the "Truman Show" market.
In order to develop an appropriate hedging strategy, the current market valuation environment must first be considered. There are a number of market valuation tools that, when looked at together, provide a fairly justifiable market valuation baseline, and allow value investors to design their hedging strategies appropriately. The following five valuation techniques were used within this analysis:
- Tobin's Q
- Shiller's Cyclically-adjusted price/earnings ratio ("CAPE")
- Total market capitalization/GDP
- Hussman's price/peak earnings ("P/PE")
- GDP trendline mean reversion
The average of the five valuation tools indicates that the current market is 45% overvalued. These five tools are useful because they are measurable, mean-reverting, make economic sense, have stable fundamental values, and have some predictive power. Other tools would not be as effective, because they would not meet all these tests. For example, P/E was not included because it does not have stable fundamentals, as earnings are volatile. P/E is a good screen in terms of relative value, but a poor measure of absolute value.
1) Tobin's Q
The first market valuation technique used was Tobin's Q. Tobin's Q can essentially be characterized as the price-to-book of the market; it measures the replacement cost of assets in relation to current market price.
2) Shiller's Cyclically-adjusted price/earnings ratio
The second test used was Shiller's CAPE ratio, which is calculated by dividing the total market capitalization of the S&P 500 by the cyclically-adjusted (for inflation) average ten years' worth of earnings. This ratio resulted in a current value of 25.4x, higher than the 1950-current CAPE average of 18.7x, and implying a market overvaluation of 36%. The expected 10-year CAGR at these levels is 3%. This year is the first time we are seeing CAPE levels that are above levels seen in 2008.
3) Total market capitalization/GDP
Market capitalization/GDP is the percentage of GDP that represents stock market value. The market capitalization/GDP of the NYSE and NASDAQ indices was 135% for 2013, illustrating a 35% overvaluation of the market.
4) Hussman's price/peak earnings
Hussman's price-to-peak earnings (P/PE) ratio was calculated from the peak in S&P 500 annual earnings. The long-term P/PE mean is 14x, whereas the ratio for 2013 is 18.6x, resulting in a 33% overvaluation from the mean.1
5) GDP trendline mean reversion
The GDP trendline mean reversion statistic is calculated from the amount of time from September 2009 and the fair value at the time of $860, and trending it forward at a rate of 6.3% as if it were trending smoothly higher as GDP does.2 Comparing the price of the S&P, currently at $1866, to the GDP trendline value of $1138 finds a market overvaluation of 64%.
Low historic dividend yield: The current S&P 500 dividend yield of 1.89% shows that markets could be potentially overvalued, as the mean historically has been 4.43%.3
High profit margins: Profit margins on the S&P 500 are currently averaged at a very high level of 9%.4 This is unsustainable, especially since profit margins are very mean-reverting.
Low taxes: The current low tax-rate environment is unsustainable. As tax rates begin to rise, people will begin to take profits as they expect tax raises, lowering liquidity.5
Considerations Given to Current Monetary Policy
By increasing the monetary base and lowering yields, commercial banks and other lending institutions stimulate the economy by underwriting more loans through the fractional reserve banking system. In the end, Quantitative Easing ("QE") encourages liquidity trades, and by lowering yields, pushes investors to take greater risks by moving up the risk curve in search of yield.
Additionally, margin debt to GDP is at a record high at 2.6%, undoubtedly facilitated by record low interest rates and availability of credit.6 Margin debt poses major risk to investors if they are forced into liquidity trades to cover their positions, steepening a market downslide.
Considerations Given To Inflationary Environment
As inflation is caused by growth in broad money, the current monetary policy environment poses great inflation risk. While stocks are generally a safe investment against inflation in the long run, inflation could still cause short-term distortions and steep declines in stock market valuations due to uncertainty. Governments may also wish to create inflation in the near future in order to reduce their relative debt loads.
In order to curb inflation, central banks may need to raise interest rates. Real interest rates would also rise, as providers of capital would demand to be compensated for greater inflation risk undertaken. This could force the economy into a recession, and cause stock market valuations to fall precipitously.
Eventually, the increase in broad money may seep into other asset classes, as well as in the demand for goods and services, causing inflation. Accompanying increases in discount rates could cause stock market declines. Due to this, one may look to hedge directly versus inflation through far out-of-the-money call options on gold, or other similar assets that could provide a hedge specifically versus inflation.
Commentary on Behavioral Factors
Herd-like behavior amongst institutional investors is a great concern, as it fuels exuberance, making bull markets longer and stronger, but also increasing risk. In other words, herding leads to reflexivity, changing market fundamentals and increasing risk by increasing valuations outside of their equilibrium range.
Quantitative anchoring and extrapolating from the past is also an important behavioral factor. The representativeness heuristic, when investors assume that future patterns will resemble past ones, is particularly relevant. After the 2013 S&P returns of 32%, many investors may extrapolate from the past and assume that the market will have a similarly strong performance this year. Individuals may also feel regret for missing last year's performance, and throw themselves into the market without other considerations. This all serves to add fuel to the fire of an asset or market bubble.
Lastly, the market seems to be currently exhibiting signs of overconfidence. The current monetary policy environment to what some refer to as the "Greenspan-Bernanke-Yellen" put artificially gives investors a sense of false security in risk-taking. As Greenspan and Bernanke both reduced interest rates to fight market falls, investors feel they can confidently take on additional risk. Therefore, overconfidence bias has also pushed investors further along the risk curve in search of yield.
A hedging strategy should be implemented in order to capture most of your portfolio's upside, yet, limit your losses. It is a lot easier to outperform the market by focusing on return of capital rather than return on capital, because of the asymmetry of market returns. Many people mistakenly assume that market returns are symmetrical, however, a 50% portfolio value drop takes a 100% gain for recovery. This is precisely why those investors who master the art of "not losing money" are typically the best investors.
These are some recommended hedging strategies (all option contracts below represent one-year contracts):
(1) Buy SPY Puts 10% Out-Of-The-Money
The cost of this hedge would be 3.4% of your portfolio value, equating to 5.4 option contracts. You would actually need to buy 6 option contracts for this portfolio value, implying a cost that is slightly higher, however, for illustrative purposes, we will assume you can buy partial contracts. This 3.4% hedge caps losses at 13.4%, implying that you would have 86.6% insurance.
Making this hedge in 2008, when the S&P was around $1400, would have allowed you to outperform the S&P 500 by 37% during the subsequent drop to $700. Insuring 87% of $1400 would have stopped your losses at $1218, whereas the market dropped to $700. If looking at log returns, you would have outperformed the market by 55%, highlighting the crippling effect of asymmetrical returns on your portfolio.
(2) Buy SPY Puts 10% Out-Of-The-Money And SPY Puts 25% Out-Of-The-Money
This alternative looks at a net-short hedge by buying SPY puts 10% out-of-the-money and buying SPY puts 25% out-of-the-money as a stronger hedge for deep declines.
This would imply a cost of 4.5%, yet, in deep-declines, it could actually allow you to make absolute returns on your portfolio.
(3) Buy GLD Calls 35% Out-Of-The-Money
This is to cost-effectively hedge against a large financial catastrophe, such as: a mass fleeing from the US dollar or spiraling inflation; or, essentially it could be seen as insurance on the solvency of the United States. QE has heightened the risk of inflation to such a high degree that a cheap hedge versus inflation and "black swans" using gold is justified. One can currently purchase 35% out-of-the-money calls on the GLD for $0.96. Thus, the cost of this hedge is actually only 0.76%.
If the GLD goes to $186, which is a realistic level if there was a large financial crisis, the return on that call option would be 1690%.
Seth Klarman was recently quoted saying, "... [Gold] is a good hedge to own should the solvency of the United States be called into question."7 If gold goes to $3,000, $5,000, or $10,000 an ounce, Klarman calls buying options on gold "the most interesting hedge."8
Investors looking to preserve their capital should highly consider one or two of these hedges.