Given the relatively extreme valuations in markets of late, and the chance that the Fed will soon take steps that may initiate a re-rating of risk, a glance at the history of market drawdowns is quite sobering (Chart 1). We are now positioned for a potentially meaningful pullback that could be a garden variety correction, or given the proper catalysts, could even range all the way up to a major bear market like those that began in 2000 and 2008.
Unfortunately, there is no shortage of such catalysts. For example, there are 1) banking problems in China, Germany, Italy, and Greece (cf. Chart 2) that could easily explode into a financial crisis; 2) there is the potential collapse of the pound sterling (Chart 3) and British economy in the wake of the Brexit decision; 3) there is the declining value of the Chinese renminbi (Chart 4), which is under pressure from huge capital outflows; and 4) there is the struggling and dysfunctional Japanese economy (Chart 5), which seems impervious to all attempts to revive it. With all these catalysts and high valuations, it makes sense to think about taking defensive measures in one's portfolio allocations.
Chart 1: Significant Drawdowns Since 1927
Source: A Wealth Of Common Sense
Chart 2: Banking Problems in Europe
Chart 3: Collapse of Pound Sterling in 2016
Chart 4: Chinese Yuan/Renminbi Falling Fast
Source: FX Exchange.com
Chart 5: Japanese Economy Struggling
Source: Zero Hedge
One big problem right now is that standard asset allocations are not very likely to work as well as they have in the past to shore up a portfolio's defenses against potential downside risk. For example, bonds are also at fairly extreme valuations, although they are better now than they were a few weeks ago. Worse yet however, bond prices have recently been highly correlated to stocks (Chart 6), which is the opposite of what one would expect if they were being used in a traditional way to hedge away portfolio risk.
So it is not clear that bonds can be used in the traditional manner or that they will prove to be effective in anything less than dire circumstances. Likewise, there is much more risk than usual in defensive stock sectors like healthcare (Chart 7), consumer staples (cf. Chart 8), and utilities (cf. Chart 9), although recent corrections have mitigated the extreme valuations somewhat.
Source: Zero Hedge
Chart 7: Healthcare Stock Valuations Are Still High
Chart 8: P/B Valuation for Consumer Staples vs. 10-Yr. Treasury Bond Yield
Chart 9: Utility Stock Valuations Extreme in Early 2016
Source: Putnam Investments
I have long favored using other kinds of defensive measures, like certain kinds of buy-write strategies (Chart 10) or certain liquid alternatives strategies like long/short funds (Chart 11). However, there are also some potential drawbacks to using buy-write funds because the trade-off for their high yields is that they are selling calls into downturns, which can make them lag the indexes during recoveries.
The drawback to long/short funds is that there are periods of time near market tops where they can consistently underperform. They more than make up for this in the long run (on average), but one has to be patient. So it also seems prudent to consider the use of managed futures funds in the current situation, because these have long been inversely correlated to equities as an asset class, and thus, they have usually outperformed during major bear markets (Charts 12 and 13).
Chart 10: Buy-Write Strategies Can Reduce Volatility
Source: Humble Student Of The Markets
Chart 11: Long/Short Funds Can Also Reduce Volatility
Source: LoCorr Fund Management
Chart 12: Much Smaller Drawdowns for Managed Futures Since 1993
Source: Managed Futures Blog
Chart 13: Outperformance of Trend-Following Strategies vs. 60/40 Stock/Bond Portfolios
In general, managed futures funds have experienced relatively small maximum declines in bear markets since 1987 (Chart 14). This compares favorably to US stocks, international stocks, REITs, and commodities. The strong inverse correlation of managed futures to both stocks and bonds (Chart 15) gives it great utility as a hedging tool under the conditions discussed above.
Chart 14: Managed Futures Less Volatile Than Most Other Asset Classes Since 1987
Source: Steben & Company
Chart 15: Inverse Correlation of Managed Futures with Stocks and Bonds
Source: Alpha Architect
One significant drawback to managed futures funds as hedging tools is that counter-trend rallies in a market drawdown can severely test one's patience, as the inverse correlation of managed futures funds means that they can go down when the market bounces upwards in such rallies. So just as with the buy-write and long/short strategies, one should probably limit the size of portfolio allocations to these approaches to some degree.
I would remain defensive, so it makes sense to hold some minor amounts of intermediate to long Treasuries, but also to hedge against interest rate risk. However, perhaps more reliable hedges would include some liquid alternatives like the Otter Creek Long/Short Opportunity Fund (MUTF:OTCRX), the AQR Long-Short Equity Fund (MUTF:QLENX), the AQR Managed Futures Strategy Fund (MUTF:AQMNX), and even some sophisticated hedge-like Closed-End Fund strategies like the Nuveen S&P 500 Buy-Write Income Fund (NYSE:BXMX).
Disclosure: I am/we are long OTCRX, QLENX, AQMNX, BXMX.
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: : This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended. This post is illustrative and educational and is not a specific recommendation or an offer of products or services. Past performance is not an indicator of future performance.