Lessons From Thursday's Market Dive: Gold, Diversification Offered Little Protection

by: David Pinsen

Market tumbles on fears of recession, Eurozone crisis

Major stock indexes tumbled on Thursday over recession fears and worries about a worsening of the financial crisis in the Eurozone. Thursday's market action reinforced some lessons about managing market risk. Below is a review of them.

Lesson 1: Diversification Doesn't Protect Against Market Risk

Diversifying among a basket of different stocks reduces stock-specific risk, but not market risk. When the market tanks, nearly all stocks get hammered. That’s what happened on Thursday, as 473 of the S&P 500 stocks were down on the day.

Lesson 2: Defensive Stocks Don't Protect Against Market Risk

This is a point Seeking Alpha contributor Sy Harding made in this article a few months ago, and it bears repeating:

The failure of defensive stocks to protect portfolios has been demonstrated over and over again. But the advice remains the same in every cycle.

After the market seemed to top out in the year 2000, the stocks most recommended as defensive stocks included Alcoa (NYSE:AA), Bristol Myer Squibb (NYSE:BMY), Citigroup (NYSE:C), Coca-Cola (NYSE:KO), Disney (NYSE:DIS), DuPont (NYSE:DD), Fannie Mae (OTCQB:FNMA), General Electric (NYSE:GE), Home Depot (NYSE:HD), IBM (NYSE:IBM), Merck (NYSE:MRK), and WalMart (NYSE:WMT). However, they plunged an average of 59% to their lows in the 2000-2002 bear market, worse than the Dow's decline of 38% and the S&P 500 decline of 49%.

The screen capture below shows the performance of each of those stocks on Thursday. Granted, some of these stocks (Fannie Mae, most obviously; Citigroup; General Electric, perhaps) haven't been considered defensive stocks for a few years, but others are still characterized as defensive by some investing columnists. All were down on the day.

Lesson 3: Gold isn't Always a Haven

As of Thursday afternoon, New York spot gold had dropped 2.49% on the day to $1,736.20 per ounce. The gold-tracking ETF SPDR Gold Shares (GLD) closed down 2.62%.

Lesson 4: Hedging Can Limit Market Risk

The screen capture below shows the performance on Wednesday of the SPDR S&P 500 Trust ETF (SPY), the SPDR Gold Shares ETF and a few put options on them that we have mentioned in previous articles. More on those below.

Up 109.09% Thursday

This is the $75 strike put option on SPY expiring in January 2012. These were the ones we pulled up for an article published on July 29, where we were looking for the optimal puts to hedge against a >49% drop in SPY. Below is a screen capture of the detailed quote for these puts as of Thursday's close (Note that the ask price in the screen shot below is $1.12; on July 29, it was $0.25.). First, though, a quick reminder about optimal puts.

About Optimal Puts

Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses an algorithm developed by a finance Ph.D. to sort through and analyze all of the available puts for your position, scanning for the optimal ones.

Up 62.59% Thursday

This is the $104 strike put option on SPY expiring in March 2012. This was the SPY optimal put option we referred to for comparison purposes in this Seeking Alpha article published August 3.

Up 37.09% Thursday

This is the $135 strike put option on GLD expiring in March, 2012. These were the optimal contracts we pulled up in this Seeking Alpha article, published on August 4th, "Why you should consider hedging if you own gold". Note that the ask price in the detailed quote below is $2.27. When we pulled up these puts for the article last month, it was $1.66.

Disclosure: I am long puts on GLD.