The Time To Hedge Is Now! At The Edge Of A Global Recession

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Includes: ADSK, BID, BYD, COF, ETFC, GT, JNK, KMX, LB, LVLT, MAR, MAS, MS, MU, RCL, SIX, TPX, UAL, ZION
by: Mark Bern, CFA

Summary

There are many reasons in the global economy to be cautious and this hedging strategy has worked well for me thus far!

Results on open positions include one loss, one break even and 41 winners this year so far.

A brief discussion of the risks inherent to this strategy.

Click to enlarge

The photo is not me! It represents how many investors may be feeling who choose not to hedge against a major loss.

Strategy Overview

If you are new to this series you will likely find it useful to refer back to the original articles, all of which are listed with links in this instablog. It may be more difficult to follow the logic without reading Parts I, II and IV. In the Part I 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. Part III provided a basic tutorial on options. Part IV explained my process for selecting options and Part V explained why I do not use ETFs for hedging. Parts VI through IX primarily provide additional candidates for use in the strategy. Part X explains my rules that guide my exit strategy. All of the above articles include varying views that I consider to be worthy of contemplation regarding possible triggers that could lead to another sizable market correction.

While I have stressed in previous articles of this series that I generally do not predict recessions or bear markets, I must admit the current investing environment sure does feel like both. This is why I hedge. I began in 2014 by using about 1 ½ percent of the value of my portfolio to hedge against a potential portfolio loss of 30 percent or more. Then, as I was able to capture some sizable gains from a few positions, my cost for that first year was reduced to less than one percent of my portfolio. An inexpensive form of insurance. Last year my gains were much more significant and I was able to offset all of my hedging cost for 2015, the remaining costs from 2014 and have plenty left over to extend my hedge well into 2016. So, now I am basically working with house money, so to speak, and my portfolio remains fully hedged against loss. For a full accounting of the results from last year and a summary of 2014, please refer to this article.

The dominoes around the globe that could fall one after the other

This recent article from Stock Charts includes ten charts that create a vivid picture of the weakness in global energy and transportation with a narrative that links the woes of energy to much of that weakness in a convincing manner. I expect energy to continue to be weak for much of 2016 and possibly into 2017 with the price of oil remaining below $35 for the foreseeable future until production is cut substantially. You can read more about my views on the energy sector outlook here.

Of course, the risk of another global financial crisis is growing and it is not all related to the looming shale oil producer bankruptcies. Many banks in Europe, especially Italy, are in far worse shape than during the crisis in 2011. Many U.S. banks, especially small and regional banks, have excessive exposure to the energy sector. Other financial institutions, even some large U.S. banks, are over exposed to losses on credit card debt and subprime auto loans. Then there are the trillions of dollars in U.S. dollar-denominated loans to companies in emerging markets where local currencies are losing value compared to the surging U.S. dollar. Many of those firms are reliant on additional debt to continue operating. For such companies, debt is becoming unaffordable at the same time that their assets are losing value and products prices are falling.

Mining companies around the globe are plagued with excess capacity, as are the many manufacturing businesses in China, especially the state owned corporations. This is causing additional stress on the financial institutions that originated and service the loans to the failing businesses around the globe. Even in the U.S., there are many weaker companies that have been able to survive primarily because of the cheap debt. But as those companies whose debt is below investment grade (or junk) need to add more debt or roll over maturing debt, it is becoming more expensive as the spread between quality and junk is widening. I expect this situation to continue to worsen forcing many more bankruptcies well outside the confines of energy.

The reported growth in China is suspect at best. If the dynamo that may have proved the savior of the global economy during 2008-09 by stimulating growth stumbles, it could prove devastating now since it represents a larger share of the global economy. The health of the Chinese economy is imperative to global stability almost to a similar degree as the health of the U.S. or European economies. All is not well in China.

Japan is in much worse shape than either China or Europe. The yen is climbing again even with negative interest rates. There is not much more that the Bank of Japan can do to calm its markets. It may be out of ammunition. Where does help come from? No clue.

Emerging markets will not be able to save the world with growth this time. Too many depend on exporting natural resources. With the prices of those resources falling through the floor and demand waning, the future is getting bleaker by the month. Even some developed countries are swooning because of the fall in commodity prices; Canada and Australia come to mind. In the emerging economy world, Russia is in recession, Brazil is in recession, a financial crisis in Argentina, and trade is falling rapidly.

The developed economies are not in much better shape. Japan is in recession, the European Union is barely growing at about 0.3 percent with several economies at the brink.

Central banks around the globe have very few tools to work with at this point. If a recession starts now those institutions we look to for relief will have already used all the traditional tools to lessen the impact of an economic downturn as well as some new and improved methods (that do not seem to be working any longer). What more can be done? I do not have an answer to that question and am afraid that neither do the central banks.

Those pointing to employment, robust retail sales, housing, and record auto sales need to look around a little further in my opinion.

The unemployment rate does not include those discouraged workers who have lost full-time employment and work in temporary or part-time jobs. If the underemployed were to be included, the unemployment rate would be in excess of ten percent. And that does not take into account the millions of Americans who have given up looking for work and are no longer included as part of the work force. The participation rate in the work force has not been this low since the 1970s.

Retail sales are not growing robustly. By comparison, in the first month of the recession beginning in 2001 y/o/y retail sales growth recorded an increase of 1.9 percent and in the first month of the Great Recession (December 2007) y/o/y core retail sales growth was at 4.5 percent. In December 2015, the y/o/y core retail sales growth reported was 1.2 percent. This is actually worse than at the beginning of either of the last two recessions.

New home sales are recovering but remain well below, not just the boom era levels, but even the historic averages since the 1960s. Existing home sales are admittedly doing better, but the trend appears to be flattening. The real problem here is that the economy benefits far more from new homes sales than existing home sales. It may be improving but the situation is still not stellar or able to drive much economic growth without a lot of help from other sectors.

I believe that auto sales peaked in 2015 for two primary reasons: demographics and the increase in subprime auto loans. When the baby boomers retire we drive less and our cars last longer. We just passed the peak years of buying by our generation and the future demand from this group is likely to drift lower in coming years. When the number of auto sales financed for subprime customers increases it means that the auto companies and the companies that finance auto sales are looking under every rock for more sales. They are running out of rocks.

Add to the above list the fact that student loans outstanding are now above $1.3 trillion and that the default rate is rising. This acts as an immense drag on new consumers entering the work force (or trying to) as they are starting out with the equivalent of a car payment without the car and some with the equivalent of a home mortgage payment without the benefit of a place to live. Then add the increased cost of healthcare. The economy has a lot dragging growth lower. It will not take much to throw the world into recession which is also portrayed in an article from The Economist. We are already on the edge. So, I just like being prepared in case the worst happens.

Results of open positions

Month Issued

Symbol

Strike Price

Current Price

Premium Paid

Current Premium

Percent Gain/Loss

Expiration Month

Sep 2015

(NYSEARCA:JNK)

$35

$31.49

$0.80

$3.50

338%

Mar 2016

Oct 2015

JNK

$34

$31.49

$1.00

$2.45

145%

Mar 2016

Oct 2015

(NYSE:BID)

$27

$19.13

$1.15

$7.70

570%

Apr 2016

Oct 2015

(NASDAQ:GT)

$26

$28.61

$1.60

$0.90

-44%

Apr 2016

Oct 2015

(NYSE:KMX)

$40

$42.15

$0.75

$2.25

200%

Apr 2016

Oct 2015

(NASDAQ:MAR)

$65

$61.59

$2.25

$5.80

158%

Apr 2016

Oct 2015

(NYSE:MS)

$25

$21.69

$0.53

$4.15

683%

Apr 2016

Oct 2015

(NASDAQ:MU)

$11

$9.69

$0.27

$2.04

656%

Apr 2016

Oct 2015

(NYSE:RCL)

$70

$67.97

$1.79

$5.25

193%

Mar 2016

Nov 2015

(NASDAQ:ETFC)

$25

$20.23

$1.05

$4.75

352%

Apr 2016

Nov 2015

GT

$27

$28.61

$0.70

$1.20

71%

Apr 2016

Nov 2015

MS

$28

$21.69

$0.58

$5.85

909%

Apr 2016

Nov 2015

RCL

$65

$67.97

$1.41

$5.85

315%

Jun 2016

Nov 2015

(NYSE:UAL)

$50

$46.98

$2.10

$4.45

112%

Mar 2016

Nov 2015

(NYSE:BYD)

$17

$14.96

$0.60

$2.25

275%

Mar 2016

Nov 2015

(NYSE:MAS)

$23

$24.97

$0.45

$0.75

67%

Apr 2016

Dec 2015

RCL

$75

$67.97

$1.80

$11.30

528%

Jun 2016

Dec 2015

MAS

$25

$24.97

$0.80

$2.30

188%

Jul 2016

Dec 2015

GT

$27

$28.61

$0.80

$2.10

163%

Jul 2016

Dec 2015

KMX

$50

$42.15

$2.50

$9.30

272%

Jul 2016

Dec 2015

(NASDAQ:ADSK)

$50

$43.26

$1.75

$8.95

411%

Jul 2016

Dec 2015

(NYSE:SIX)

$45

$47.11

$1.25

$2.50

100%

Jun 2016

Dec 2015

RCL

$75

$67.97

$1.80

$11.30

528%

Jun 2016

Dec 2015

GT

$28

$28.61

$1.25

$2.25

104%

Jul 2016

Dec 2015

ADSK

$50

$43.26

$1.80

$8.95

397%

Jul 2016

Dec 2015

SIX

$45

$47.11

$1.20

$2.50

108%

Jun 2016

Dec 2015

(NYSE:LB)

$85

$84.00

$2.50

$6.50

160%

May 2016

Dec 2015

(NYSE:LVLT)

$48

$45.86

$1.90

$5.40

184%

Jun 2016

Dec 2015

(NYSE:TPX)

$60

$53.39

$2.50

$9.00

260%

Jun 2016

Dec 2015

UAL

$50

$46.98

$2.00

$6.25

213%

Jun 2016

Dec 2015

MAS

$25

$24.97

$0.85

$2.30

171%

Jul 2016

Dec 2015

ETFC

$27

$20.23

$1.25

$6.75

440%

Jul 2016

Jan 2016

(NYSE:COF)

$60

$60.15

$1.95

$5.20

167%

Jun 2016

Jan 2016

BID

$24

$19.13

$4.10

$5.70

39%

Jul 2016

Jan 2016

BID

$20

$19.13

$3.60

$4.30

19%

Jan 2017

Jan 2016

(NASDAQ:ZION)

$18

$19.90

$0.77

$1.40

82%

Jul 2016

Jan 2016

ZION

$15

$19.90

$0.71

$1.21

70%

Jan 2017

Jan 2016

ZION

$18

$19.90

$0.58

$1.40

141%

Jul 2016

Jan 2016

LB

$75

$84.00

$2.10

$4.60

119%

Aug 2016

Jan 2016

SIX

$40

$47.11

$1.05

$1.20

14%

Jun 2016

Jan 2016

MAS

$22

$24.97

$0.90

$1.15

28%

Jul 2016

Jan 2016

GT

$25

$28.61

$1.40

$1.40

0%

Jul 2016

Jan 2016

COF

$55

$60.15

$1.81

$3.25

80%

Jun 2016

Month Issued

Symbol

Strike Price

Current Price

Premium Paid

Current Premium

Percent Gain/ Loss

Expiration Month

Click to enlarge

If I counted correctly I have a total of 43 open positions that were originally listed in my previous articles with one showing a loss and one at break even. I have five positions that will expire in March. I intend to hold those positions for a few weeks longer or until I see evidence that a rally is imminent. If I expect a significant rally is coming I will write about it. As of the moment, Thursday night February 12, 2016, Asian markets are down. The price of oil is up on new rumors of OPEC and Russian oil production talks but the article that is not showing up is one quoting a Russian oil executive who explains that there is nothing to the rumors other than a few producing nations trying to prop up the price. I agree with him. It is a rumor until it is fact. Without Saudi Arabia making a public announcement, I will not believe that there is anything real afoot. Thus, any rally in oil will be very short-lived and have limited impact on equities.

I will do my best to add some new positions to consider with premiums on strikes that may seem out of reach now but that could come to us if there is a rally. Watch for a part two either tomorrow or by the weekend.

Discussion of Risk

If an investor decides to employ this hedge strategy, each individual needs to do some additional due diligence to identify which candidates they wish to use and which contracts are best suited for their respective risk tolerance. I do not always choose the option contract with the highest possible gain or the lowest cost. I should also point out that in many cases I will own several different contracts with different strikes and different expiration months on one company. I do so because as the strike rises the hedge kicks in sooner and I also do not want all of my positions to expire at once, but I buy a mix to keep the overall cost down. I currently own positions that expire in March, April, May, June, July and August of 2016 as well as some that expire in January 2017. My goal is to commit approximately two percent (but up to three percent, if necessary) of my portfolio value to this hedge per year. If we need to roll positions before expiration there may be additional costs involved, so I try to hold down costs for each round that is necessary. I have been fortunate enough this past year to have ample gains to cover my hedge costs for the next year. The previous year I was able to reduce the cost to below one percent due to gains taken. Thus, over the full 21 months since I began writing this series, my total cost to hedge has turned out to be close to zero.

I want to discuss risk for a moment now. Obviously, if the market were to turn back higher beyond January 2017 all of our option contracts that we have open could expire worthless. I have never found insurance offered for free. We could lose all of our initial premiums paid plus commissions, except for those gains we have already collected. If I expected that to happen I would be taking profits on the open positions now. But it is one of the potential outcomes and readers should be aware of it. The longer it is before the next recession the more expensive the insurance may become. 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 whether the market will turn into a full-blown bear or regain the high ground 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 two percent per year) to insure against losing a much larger portion of my capital (30 to 50 percent). But this is a decision that each investor needs to make for themselves. I do not commit more than three 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 before a major market downturn has occurred. 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, at this point, I would expect the next bear market to be more like the last two, since the market has, in my opinion, defied gravity until 2016. Anything is possible but if I am right, protecting a portfolio becomes ever more important.

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.

For those who would like to learn more about my investment philosophy please consider reading "How I Created My Own Portfolio Over a Lifetime, or for those who would rather listen to a podcast on the same subject, you may want to consider my interview by IITF.com which can be found here.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I own put options on all stocks listed in this article.