I hope that my articles provide the above to some investors who feel they need it!
Back to An Indecisive Market
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, IV and X. In 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 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 sizeable market correction.
I have stressed in previous articles of this series that I generally do not predict recessions or bear markets. Recessions and market corrections are just part of the investing experience. They occur when we least expect them. This is why I hedge. I began in 2014 by using about 1½ 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. It amounts to an inexpensive form of insurance and provides me with peace of mind. 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 and 2015, please refer to this article.
I want to review some important aspects of the strategy before introducing my new candidate for consideration. First, this is a hedging strategy, it is not a trading strategy. I am not predicting an imminent market crash. I have modified the strategy from the original few articles in one way - I now add new positions before some of my shortest-duration positions expire when stocks rally. That makes me temporarily overhedged. It also allows me some flexibility to take profits on those positions that are near expiration with good gains. In the past, I have held onto those positions until expiration and watched many gains of 300-600 percent decay into expiration when the market rebounds. Now, I try to replace some positions early (before expiration) when the market gives me a better entry point - as it has done this week. For more on this topic, please consider the previous article in this series linked at the top of this article.
If I hold positions in eight companies, I try to distribute my hedge as equally as I can across each of them. In other words, I have one-eighth of my hedge in each company. If I hold positions in ten companies, I try to hold about ten percent of my hedge in each.
In this article, the author discusses the rising delinquencies in credit card debt which will lead financial institutions with exposure to increase reserves for bad debt. If Jamie Dimon of JPMorgan Chase is right in his statement that credit "is going to get worse," then my candidates Morgan Stanley (NYSE:MS) and, especially, Capital One Financial (NYSE:COF) will perform well in the coming months.
Combine that with record levels of margin debt not seen even in 2000 or 2007 with rising credit defaults, and suddenly I begin to suspect we are nearing the point at which something will have to give (and not in a good way). I highly recommend reading this article, because the charts alone are worth the effort.
Finally, it appears that subprime mortgage lending is back in vogue. I am sure I do not need to explain why this bothers me.
If I miss the next ten percent move higher, I will not be distressed. As long as I miss the majority of the next big leg down, I will be a happy camper from an investment performance point of view. I do not pick tops or bottoms - I try to invest in the direction of the primary trend. There is no obvious primary trend at the moment. Thus, I remain cautious and fully hedged.
Below is my newest candidate to consider for hedging. You will find the contract I intend to use, including the strike price and expiration month I want to buy. I also list the premium at which I would like to own the contract(s) as well as the recent bid and ask premium, the number of contracts needed to protect 1/8th of each $100,000 in the equity portfolio against a loss of 30% or more in the broader market. What I mean is that I own at least eight positions with the number of contracts listed for every $100,000 in value of the equity portion of my portfolio. I aim for coverage of about $3,750 for each position. That amount is equal to 1/8 of $30,000. If the market falls by 30 percent, I want to protect against the loss of $30,000 for each $100,000 of value in my portfolio. Also included is the strike price, the percent of expected gain if the target price is hit, the target premium for each candidate and the percent of cost for each $100,000 of equity value represented by each position. (All prices and quotes are as of the market close on Thursday, June 16, 2016.)
Monster Beverage Corporation (NASDAQ:MNST)
Monster is very overvalued at this point, in my opinion. The cash flow from operations is falling, and revenue growth has slowed to only 8.5 percent year over year (yoy). The company recently purchased about 6.3 percent of outstanding shares at a price of $156 per share. But that plus the growth rate do not justify a trailing price/earnings (P/E) ratio of 44 or a forward P/E ratio of 33 (based upon consensus estimates). During the financial crisis, shares of MNST fell more than 60 percent in six months from the peak in 2007 to early 2008, while the broader market fell by less than half that amount during the same time. I expect a repeat performance if the economy falls into recession again.
Current Share Price
Target Share Price
Current Bid Premium
Current Ask Premium
# of Cont.
Est. % Gain
This position should hedge approximately 17 percent of $100,000 in equity portfolio value. I am straying away from the usual 1/8 (or 12.5 percent) for a position, because the share price is higher than is usually the case for most of my positions. I need only one January 2017 MNST put option contract, as described in the above table. The expected gain, should the stock hit my target price of $65 prior to the option expiration, is $5,160.
The company is facing increased competition from the stalwarts in the industry as well as other small entities eyeing the fat margins. Price competition for market share has begun, and I expect it to intensify during a recession. When people lose jobs, they no longer need, nor can they afford, an energy boost. As lower-cost alternatives become more pervasive in the marketplace, MNST margins and cash flow will get squeezed.
I do not intend to chase the premium higher. I set target premiums for a reason. I do not want to dilute the potential gains and, therefore, diminish the potential value of any hedge. I may go a nickel higher if I cannot find enough positions to meet my needs, but rarely will I go any further. The option contract listed is trading within a range that includes my target premium, so unless the market tumbles tomorrow, I expect to be able to fill this position near the open.
Discussion of Risk
I want to discuss risk for a moment now. Obviously, if the market were to rally 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. 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 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 (30-50 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 (which is where we are today, in my opinion), 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 now. 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.