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Summary

  • It has been almost 3 years since the market experienced a 10% correction, which is the 5th longest drought on record.
  • U.S. corporations, which were the biggest buyers of stocks in the first quarter of 2014, have cut their announced buybacks to the lowest level in seven quarters.
  • The cost of protection is cheap and investors should consider hedging their portfolios.

The S&P 500 is now up 187% since troughing in March 2009 and it has been almost 3 years since the market experienced a 10% correction.

As shown in the chart above, each of the major rallies over the past 15 years have been followed by a significant correction. We think that this rally is getting very long in the tooth and we wouldn't be surprised if we have a healthy pullback in the coming months. For the most part this rally has been Fed-induced (through low rates and easy monetary policy) and economic fundamentals may not be able to support current stock prices. That said, since we won't be able to time the market top, we feel that now is as good of a time as any to start implementing a short-term "hedge" for your portfolio.

U.S. Corporations Have Recently Cut Buybacks

According to TrimTabs, U.S. corporations, which were the biggest buyers of stocks in the first quarter of 2014, have cut their announced buybacks to the lowest level in seven quarters.

Buybacks have been one of the big drivers of earnings growth which, in turn, has helped to justify higher stock prices. But, with fewer buybacks, there may not be enough buyers to pick up the slack.

The Risk Of Buying Stocks At Current Levels

According to John Hussman, at current valuations, investors could realistically expect to experience negative nominal total returns over the next 5-7 years.

I'm not saying a market crash is imminent, but it is a risk because very reliable valuation methods (that have remained reliable even in the recurring bubbles since the late-1990's) presently estimate negative prospective nominal total returns for the S&P 500 on every horizon of 7 years or less, and an annual total return of about 1.9% over the coming decade. On the other hand, these same methods projected negative 10-year prospective returns - even on optimistic assumptions - at the 2000 peak. While those projections turned out to be perfectly accurate (indeed, the 10-year total return of the S&P 500 was still negative even after the index had nearly doubled from its 2009 low), it also means that the overvaluation of the S&P 500 Index in 2000 was even greater than it is today. As I've noted before, the median S&P 500 component is more overvalued today than in 2000, and the average component is similarly overvalued. It's only the capitalization-weighted valuation that was higher in 2000, primarily because of eye-popping valuations of large technology companies.

Why Hedge?

First and foremost, it's important to remember that market corrections happen. As a matter of fact, we would add market corrections to the list of things in life that are guaranteed. Just like death and taxes, market corrections are a way of life. That said, investors need to EXPECT, and more importantly, PLAN for major corrections.

Investors often forget that a significant market correction can wreak havoc on even the highest-quality, dividend-paying stocks. It's actually difficult to find a dividend stock that didn't experience a decline of at least 30% during the 2008 recession.

A portfolio hedge could have reduced these losses significantly... without having to sell your stock or give up your dividend. Investors can plan for a market correction by taking the necessary steps to hedge their portfolio. In our opinion, a protective put hedge strategy is the easiest and most cost-effective way to hedge a portfolio.

The Cost of Protection Is Cheap

The CBOE Market Volatility Index (VIX) is a popular measure of the implied volatility of S&P 500 index options. Often referred to as the fear index or the fear gauge, it represents one measure of the market's expectation of stock market volatility over the next 30-day period.

As shown in the graph above, the VIX closed at 11.68 yesterday, which is very close to all-time lows. In theory, when expectations of future implied volatility are so low, it is a contrarian indicator that investors are overly optimistic about the future. In other words, when the VIX is low, there isn't enough "fear" in the market. Historically, market corrections tend to spawn when implied volatility (or fear) is low. Note: iPath has an ETN that tracks short-term VIX futures, iPath S&P 500 VIX (NYSEARCA:VXX), which is also a good proxy for future implied volatility.

That said, this is also the best time for an investor to purchase protective puts because the cost of protection is extremely low. Implied volatility is one of the main variables in option pricing models and as implied volatility declines, so does the price of the option.

Protective Put Strategy Overview

The main purpose of hedging your dividend portfolio is to limit your downside market exposure (i.e., protect your capital base), while keeping your dividend income intact. As we said above, we believe that purchasing a protective put is the easiest (and most cost effective) way to hedge your portfolio.

We like to use options on the S&P 500 ETF (NYSEARCA:SPY) for our protective put strategy. Remember that we are only trying to "hedge" the general market exposure in our portfolio and the S&P 500 is a great proxy for the general market. In addition, SPY options are extremely liquid, which makes them very easy to trade.

No hedge is perfect, but a protective put position should help dampen the volatility in your portfolio due to a decline in the general market. Yes, you will be giving up some upside if the market rallies, but that is the nature of a hedge. Whether or not you decide to hedge your own DIY Dividend Portfolio will depend on your specific market outlook and risk tolerance.

Note: If you are unfamiliar with options, there are some great free websites out there to educate yourself (like The Options Industry Council).

Hedging 101 (Step-by-Step)

As we have previously discussed, this rally to historic highs is getting very long in the tooth and we believe that the next 3-6 months will remain volatile. That said, since we won't be able to time the market top, we feel that now is as good of a time as any to start implementing a short-term "hedge" for your portfolio.

Below is a step-by-step procedure that we follow when implementing a protective put strategy. Hopefully, this will help you implement a similar strategy for your own portfolio.

Step #1: Determine How Many Puts to Buy

Every portfolio is different, but the weighted average Beta of your portfolio is a good metric to use to estimate your portfolio's general market exposure (i.e., systematic risk). For example, if your portfolio Beta is 0.50, the volatility of your portfolio should theoretically only be half that of the general market (i.e., if the market declines 1%, your portfolio should only decrease 0.5%).

For example, let's say you have $100,000 of long stock exposure, with a weighted average Beta of 0.75. Theoretically, if the S&P 500 declines 10%, your portfolio should only decline 7.5%. That said, you would need to buy approximately 4 SPY puts to hedge your portfolio:

Underlying Value of 1 SPY Option Contract:

$194.70 x 100 = $19,470

Contracts Needed to Fully Hedge Portfolio:

$100,000 / $19,470 = 5.14 Contracts

Beta-Adjusted Contracts:

5.14 x 0.75 = 3.85 Contracts

Step #2: Determine a Strike Price and Term

In general, we prefer shorter-term options (less than 4 months until expiration) over longer-term options and we prefer "in-the-money" options over "out-of-the-money" options. We have these preferences because we try to limit the "time value" exposure in our protective put. In other words, we want as much "intrinsic value" as possible in our put option. For put options, the intrinsic value is the difference between the strike price and the underlying stock price and we want the value of our put option to track as closely as possible to the underlying change in the price of SPY.

Choosing a strike price and expiration date for your put option is ultimately a personal decision. Some investors may prefer longer-dated options because they have to be "rolled" less frequently or they may prefer "out-of-the-money" options because they are less expensive. However, these decisions will ultimately affect both the cost of the hedge as well as the degree of protection that the protective put will provide. So it is critical that you understand the trade-offs of these decisions before implementing this strategy.

That said, we suggest targeting the September or October 2014 Put options, which would give you 3-4 full months of protection. As expiration approaches, you can reassess the market to determine whether or not you want to roll the position for another few months.

As far as strike price goes, we try to purchase a strike with a Delta of .60-.70. Without getting too technical, an option's delta can be used as a proxy for the probability that the option will finish in-the-money. In other words, an option with a delta of .70 theoretically has a 70% chance of finishing in-the-money. The higher the delta, the greater the intrinsic value (and the greater the cost)...so there is definitely a cost/benefit tradeoff when picking a strike price. That said, we recommend targeting a the $200.00 strike price for the September or October 2014 put options.

Step #3: Determine How Much Protection You Think You Need

Timing is everything when using options and it's important to estimate how low you think the market could go (over the term of the option period) so that you will be properly protected. The obvious tradeoff of buying a protective put for your portfolio is...cost.

The key takeaway here is that you shouldn't pay for what you don't need.

You can offset part of the cost of a protective put by selling an out-of-the-money put with a lower strike price (and the same expiration). Essentially this would create a "put spread," where you would limit your maximum profit (but it will also lower your cost of protection).

For example, since we think that the market could drop 10% in the next 3-4 months (which would equate to SPY falling to approximately $175.00), we would recommend selling the September or October 2014 put that has a strike price of $175.00. In other words, this spread position will protect you from a market correction up to 10.0%. However, if the correction is greater than that (i.e., if SPY drops below $175.00), your portfolio will be unhedged. This is why it's important to really think about how low you think the market could go before you decide whether or not you want to sell an option with a lower strike to reduce the cost of your hedge.

Summary

No hedge is perfect, but a protective put position should help dampen the volatility in your portfolio due to a decline in the general market. Yes, you will be giving up some upside if the market rallies, but that is the nature of a hedge. A hedge is essentially an insurance policy for your portfolio and whether or not you decide to hedge your own portfolio will depend on your specific market outlook and risk tolerance.

Source: Are You Prepared For Correction 2014?