US Investors Have Never Been Richer....Time To Hedge Your Prosperity?

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Includes: SPY, USO
by: Arbitrage Trader

Summary

Why Us investors are richer than ever.

Lessons from history tell us that wealth needs to be protected.

There are a number of ways Americans can maintain their current prosperity.

When the Egyptian Pharaoh Sesostris started having strange dreams about seven starving cows and seven ears of wheat, he could have dismissed them as silly dreams and continued doing whatever pharaohs do. Instead, he searched for someone who could interpret those dreams (Joseph, 11th son of Jacob) and found out that they predicted grim times ahead. For the next seven years his kingdom would be rich and crops plentiful, but following that there would be seven years of famine. Egypt would surely starve. Thankfully, the pharaoh took Joseph's advice and stored 20% of all grain during the seven abundant years, averting disaster when seven years of famine took hold.

The great stock market rally from the '09 low was 7 years old last month. Now I don't expect many of you have been storing away grain all this time, and I don't think 7 years of famine are very likely, but if history has told us anything at all, it is that good times cannot last forever. And before you think 'not another article about doom and gloom and a stock market crash', let me assure you this isn't. On the contrary, this is an article about how good things are currently.

Warren Buffett's annual letter to Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) shareholders stated that, 'the babies being born in America today are the luckiest crop in history'. We can debate how 'lucky' anyone is to be born into a world where terrorism and divisions seem worse than ever, but his letter deals in facts, and the fact is the current $56,000 GDP per capita is the highest in history. In real terms, GDP per capita is six times higher than when Warren Buffett was born in 1930.

Let's take a look how the last 7 years made the average American investor richer than ever.

1. The stock market

The best measure for the stock market is the SPDR S&P 500 ETF Trust(NYSEARCA:SPY)

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source: Barchart.com

The 600% increase Warren Buffett talks about pales in significance to the 46000% increase in the Dow Industrials from the same period. With the stock markets very near all time highs, we can assume the average investor is doing better than ever.

I hope too many of you aren't shaking your heads at this. We all have different experiences in the stock market, and the majority of people have no exposure at all. The wealthiest 10% Americans are said to own 80% of stocks, and according to data from the Federal Reserve, America has the lowest level of stock ownership in 18 years. But for the premise of this article, we will assume readers are involved in the stock market and their portfolios are reflecting the current prices.

2. The dollar

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The DXY Dollar Index compares the Dollar to a basket of major currencies. The chart says it all really. The winding down of QE and a new Fed Chair has helped boost the Dollar to levels last seen in 2003. Many readers may have taken a European holiday recently, or are driving foreign cars; it is a lot cheaper to do so.

3. Oil Prices

We chose United States Oil Fund LP (NYSEARCA:USO) to measure oil price.

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According to CNN there was a gas station pumping oil in Ohio for $1.21 a gallon in January '16. AAA puts the national average currently at around $2 and a few days ago declared that gas prices in Q1 '16 were the lowest in 12 years, saving Americans nearly $10bn compared to Q1 '15.

I actually read some comments at the bottom of the CNN article, and there was a suggestion that people horde some oil in case prices go up. I think the commentator has the right idea, but there are better, safer ways to protect against rises. More on this later.

4. Interest rates, inflation and Treasury yields.

The ironic situation here is that while the dollar has its highest buying power in terms of inflation and exchange rate, the average person can take credit at all time low interest rates. It is a win win situation for a dollar holder.

What happens when you are on top of the world and you forget to hedge properly?

The problem here is we never know when we are at the top. We can only look at past and current data to make an informed decision about the state of affairs today. Let's make a simple calculation of how much "USO" you can buy today compared to 1/1/2009 if you were invested in the SPY. With $1000 you could have bought nearly 30 shares of USO in 2009. Those $1000 dollars invested in SPY are at least $2000 now and at the current USO price you can buy almost 210 shares of USO. In terms of USO you are 7 times richer. The calculation with an European good or a Russian real estate is not that spectacular, but it is the conclusion that is important. We got richer for real and it is good to preserve our profits.

The recent sell off in some Biotechnology stocks and most Oil and Gas companies gives us a good example of how one day's hero is the next day zero. Just look at these 2 charts here as a proof:

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I wonder how many investors thought about protection at the highs of those charts?

How to hedge and preserve wealth

1. Buy some oil. At least to hedge your oil related expenses such as gasoline consumption. It is fairly easy to calculate how much your family spends in an average month at current prices. Long dated calls in USO or related entities can be used to lock in today's prices. It's preferable to a garage full of oil barrels!

2. Take some credit and invest your dollars abroad. Russia real estate for example. Russia is one of the countries that suffers the most from the price decline in oil. Even after the recent recovery, the Ruble is down 50% against the dollar and the real estate prices are hardly changed in rubles. This means that they are selling at a large discount for international buyers compared to 2 years ago. Real estate will save the inflationary risk and will give a nice currency hedge. Russia is just an example close to me. I am sure everyone has his own Russia to invest in.

3. Avoid baloney stocks. This is a must in all times, but after a 7 year run in the markets the sentiment is to just buy everything. Most bubble stocks and entities follow a similar trajectory to the upside fueled by little more than greed. This pattern has repeated over and over. Compare the below chart of the Tulip bubble of 1634 to Valeant (NYSE:VRX) posted above:

Familiar? It seems history repeats and we never learn.

4. Buy some floating rate fixed income. There is a lot of intelligent debate on whether the Federal Reserve will raise rates further. But every debate ends the same way: no-one knows for sure. All we know is that we can preserve any benefits we currently experience from low interest rates (for example, low mortgage repayments) by benefiting from a raise that should hurt us. Floating rate notes can be tied to Libor allowing investors to profit from any rise in rates.

5. Build a basket of currencies. The easiest way to do this is to simply short the DXY in the spot or futures markets, but this may not appeal to all. A less risky option is to open a US bank account denominated in foreign currencies. There are a lot to choose from, and they come in very handy when you go on holiday and you have already exchanged your Euros at rock bottom prices.

6. Short everything. This of course is a joke, but shorting is the best way to hedge and can be used as a plan B.

Conclusion

This article is by no means a comprehensive research paper on America and the wealth of its citizens. Not all the points will apply to all the readers. It's main purpose is to inspire readers to assess their own situations. If you are thanking your lucky stars that things are so great right now, then it is perhaps time to preserve this situation. Of course things may continue to get better, in which case your hedges will cancel out any added benefits. This was probably the thought process of a long term VRX throughout 2015. What would they give to turn back the clock? I personally think it is time to minimize your maximum regret.

Author's further note. I had one comment in one of my articles that stated "I don't care. I buy and I make money". This is the thing that should frighten you the most. When a person is on top of the world he sees only the bright side of life. Unreasonable risk taking based on how good your results were in the past always finishes with a hard landing. You will see a lot of portfolio managers that were buy and hold that will act like they did something very special. In fact they did not. They were just on the right place at the right time. At least consider the hard landing as a possibility and be "pre-active" not reactive.

Disclosure: I am/we are long USO.

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 am long SDS which is short SPY