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Summary

  • The article begins with a brief overview of the series containing links to detailed explanations available in earlier articles.
  • Another reason why it is time to hedge.
  • Two new candidates for consideration to use in the strategy.
  • The article concludes with a discussion of the risks of employing this strategy versus not being hedged.

Back to Part VII

In the first article of this series I provided an overview of a strategy to protect an equity portfolio from heavy losses in a market crash. In Part II I provided more explanation of how the strategy works and gave the first two candidate companies to choose from as part of a diversified basket using put option contracts. I also provided an explanation of the candidate selection process and an example of how it can help grow both capital and income over the long term. In Part III I provided a basic tutorial on options.

In this article I will provide an explanation why I do not use ETFs or the respective put options. I will also provide two more candidate stocks to consider for use in this strategy.

I want to make it very clear that I am not predicting a market crash. Bear markets are a part of investing in equities, plain and simple. I like to take some of the pain out of the downside to make it easier to stick to my investing plan: select superior companies that have sustainable advantages, consistently rising dividends and excellent long-term growth prospects. Then I like to hold onto those investments unless the fundamental reasons for which I bought them in the first place changes. Investing long term works! I just want to reduce the occasional pain inflicted by bear markets.

What could cause the next recession? As I mentioned in Part VII, continued improvement in the housing market is one of the keys to sustained economic growth. The improvement does not need to be huge, just positive. However, this recent chart by Robert Shiller, Yale economist, is an eye opener. What Shiller has done, if I understand it correctly, is to remove inflation and adjust for average home size and certain amenities to come up with the housing price trend since 1890. His logic seems to be that one cannot really compare an average home in 1890 (without central heating and air conditioning, indoor plumbing, electricity and many other features that were not widespread then) to an average home today without adjusting over time for those changes.

The only real bubble in real estate prices (represented by the blue line) that has occurred over all this time happened in the run-up before the Great Recession. You can download the file and chart at this link. Just click on the link called "Excel File xls" in the fourth paragraph that talks about Mr. Shiller's book "Irrational Exuberance."

But if you look closely, you will see that US real estate has climbed back well above the trend line (measured on the left axis). This appears to imply that home prices may need to fall as much as 20-30 percent from current levels. We all know what kind of a mess that could cause in our economy.

We are already past the average duration of all bull markets since 1929. The current bull market has now surpassed in length all but three bull markets during that time period (out of a total of 15). So, I am preparing for the inevitable next bear market. I do not know when the strategy will pay off, but experience tells me that we are probably within 18 months of when we will need to be protected. I do not enjoy writing about down markets, but the fact is: they happen. I don't mind being down by as much as 15 percent from time to time. But I do try to avoid the majority of the pain from larger market drops. To understand more about the strategy, please refer back to the first and second articles of this series. Without that foundation, the rest of the articles in this series may not make sense and could sound more like speculating with options.

The next two candidates are from the Consumer Goods Sector. Once again, when a recession hits many consumers become more careful about how much they spend and what they spend it on. When something is not broken it does not usually get replaced during a recession. We tend to try to make things last a little longer when the economy is sputtering.

My first candidate for this article is Tempur Sealy (NYSE:TPX) created by the recent acquisition of Sealy by the former Tempur World, Inc. The company produces and distributes mattresses and pillows; sales are predominantly domestic (69 percent of total). TPX has two potential factors that could spell trouble. The first is that household formations have slowed in the U.S. even though the real estate market has been recovering (for more on this see a link to an article in Part VIII). It is important to note that all-cash purchases of homes accounted for 42 percent of all home sales according to a December article from Market Watch. I have read other articles placing the percentage even higher. What this means is that a significant number of home sales have been to large commercial investors such as The Blackstone Group (NYSE:BX) and others. Here is an interesting article from Bloomberg with some numbers to consider. The point is that when home prices appreciate too much investor demand will dry up and home sales (and prices) could fall again, further hampering household formations due to the fear factor. Why buy a home and make the biggest investment of a lifetime (for most people) into a falling market? The sluggish job market is not helping as more people remain single longer and choose to live with parents or friends. Increased household formations usually help TPX product sales; a slower trend hurts. The other potential problem facing TPX is that the company is highly leveraged (debt-to-capital is 67 percent) and a large portion of that debt is floating rate. This means that as interest rates increase so will interest expenses. I do not expect a spike in interest rates (which would be a major problem for TPX) for several years, but I do expect rates to rise modestly over the next year or more. Slack demand, high leverage and rising interest costs do not make for a strong position from which to enter a recession.

TPX was privately held prior to December 2003 so price history is not available for the earlier recession. In 2007 TPX stock hit $37.87 per share and then dropped by 90 percent to $3.84 in 2009. But even without a recession, but rather just a mere threat of slowdown in the economy took the price from a high of $87.43 in April of 2012 down to $20.70 in June of the same year for a 76 percent drop. I hope that adequately demonstrates how volatile this stock can be with a beta of 2.12 according to Yahoo! Finance. The current price is back up to $52.49 and I believe that the share price could easily fall to $12 if a real recession were to occur.

To take advantage of this situation I like the TPX January 2015 put option with a strike price of $25 selling for a premium of $0.35 for a cost of $35 per contract (plus commissions). The potential gain if TPX shares fall to my target is $1265 per contract, or 3,614 percent ($25 - $12 = $13; $13 x 100 shares = $1,300; $1,300 - $35 cost = $1265; $1265 / $35 = 3,614%).

We need three contracts to protect $3,795 of portfolio value. This amount is slightly above the $3,750 that represents 12.5 percent of a potential loss of 30 percent on a portfolio of $100,000. The total cost is $105 (plus commissions) or .105 of one percent for a $100,000 equity portfolio.

Alternatively, you can go as high on the strike for the TPX January 2015 put option as the strike of $32 for $0.85 with the potential gain of $1,915, or 2,253 percent. It could give you more potential protection earlier if you can get it. You would need just two contracts for a cost of $170 (plus commissions). Stay away from contracts with low open interest. I like at least 100 contracts of open interest.

The other candidate is Goodyear Tire (NASDAQ:GT). Whenever a recession hits auto sales fall off and people seem to make those tires last a few thousand miles longer. It never fails to wreak havoc with GT's top and bottom lines. In 1999 GT stock traded as high as $66.75 but fell to a low of $3.35 in February 2003. Similarly, the high in 2008 was $30.10 and the low in 2009 hit $3.17. The percentage decreases were 95 percent and 89 percent, respectively. I like consistency. In 2000, the company paid a dividend of $1.20 per share, but suspended regular dividends in 2001. The company has recently reinstated a quarterly dividend of $0.05 ($0.20 annually) as of December of 2013. Common shares outstanding have increased from one year to the next. Debt is also increasing having risen from $2.2 billion in 2009 to $6.2 billion as of the end of fiscal 2013. The aftermarket competition is heated and GT is losing share in some markets while gaining in others. Tire manufacturers in China are competing on price putting pressure on margins in an industry with already thin margins. GT net profit margins were up to about 3 percent in 2013 from 2.3 percent in 2012. There isn't a lot of "margin" for error. When sales drop, margins turn negative in a hurry. I expect GT shares to drop to $8 or less during the next recession from current levels of $24.30 (as of the close on May 8, 2014). I like the January 2015 put option with a strike at $15 and selling for a premium of $0.30. Each contract will cost $30 (plus commissions) and represents the right to sell 100 shares. The potential gain is $670 per contract, or 2,233% (($15 - $8 = $7; $7 x 100 shares = $700; $700 - $30 cost = $670; $670 / $30 = 2,233%). This is cheap insurance that would require only $180 for six contracts to protect against a potential loss of $4,020; slightly more than the $3,750 that would represent 12.5 percent (1/8) of 30 percent loss to a $100,000 portfolio.

Remember, we are only seeking to avoid a loss by protecting that portion we may lose if the market falls by 30 percent. If stocks fall even further in a prolonged bear market, it is very likely that these (and the other candidate) options will fall below the target which would provide the additional protection needed.

I want to discuss risk for a moment now. Obviously, if the market continues higher beyond January 2015 all of our option contracts could expire worthless. I have never found insurance offered for free. We could lose all of our initial premiums paid plus commissions. If I expected that to happen I would not be using the strategy myself. But it is one of the potential outcomes and readers should be aware of it. And if that happens, I will initiate another round of put options for expiration in January 2016, using from three to five percent of my portfolio to hedge for another year. The longer the bull maintains control of the market, the more the insurance will cost me. But I will not be worrying about the next crash. Peace of mind has a cost. I just like to keep it as low as possible.

Because of the uncertainty in terms of how much longer this bull market can be sustained and the potential risk versus reward potential of hedging versus not hedging, it is my preference to risk a small percentage of my principal (perhaps as much as three percent) to insure against losing a much larger portion of my capital (30 percent). But this is a decision that each investor needs to make for themselves. I do not commit more than five percent of my portfolio value to an initial hedge strategy position and have never committed more than ten percent to such a strategy in total. The ten percent rule may come into play when a bull market continues much longer than expected (like three years instead of 18 months). And when the bull continues for longer than is supported by the fundamentals, the bear that follows is usually deeper than it otherwise would have been. In other words, I expect a much less powerful bear market if one begins in 2014; but if the bull can sustain itself well into 2015, I would expect the next bear market to be more like the last two. If I am right, protecting a portfolio becomes ever more important as the bull market continues.

As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other's experience and knowledge.

Source: The Time To Hedge Is Now! Do It For Less - Part VIII

Additional disclosure: I do own put options on the companies as described in the article.