The Limits Of Defensive Stock Allocation
In a Seeking Alpha article published last year ("Lessons From Thursday's Market Meltdown"), we noted that defensive stocks don't protect against market risk. On Monday, an item in the Lex column ("Safety on Wall Street") made a similar point, albeit more colorfully. After pointing out the benefits of investing in US Utilities now -- that they lack exposure to the problems in Europe, and, as dividend-payers, are positioned to attract investor interest if central banks keep discount rates low in response to a European crisis -- Lex noted the potential downsides:
Remember how little relative outperformance can mean when things get ugly, though: in real money utilities dropped 46 per cent in the last crisis. Unless you have a stock-only mandate, sector allocation during a collapsing market is like deciding whether to use the salad fork or the dinner fork to stab yourself in the eye.
Of course, there is a way of investing in utility stocks without risking another 46% drop -- an investor can buy them and hedge. The table below shows the costs, as of Tuesday's close, of hedging the most actively-traded American utility stocks against greater-than-20% declines over the next several months, using optimal puts.
For comparison purposes, I've added the Utilities Select SPDR (XLU) to the table. First, a reminder about what optimal puts are, and a note about decline thresholds; then, a screen capture showing the optimal put option contract to hedge one of the utility stocks below, FirstEnergy Corporation (FE).
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.
In this context, "threshold" refers to the maximum decline you are willing to risk in the value of your position in a security. You can enter any percentage you like for a decline threshold when scanning for optimal puts (the higher the percentage though, the greater the chance you will find optimal puts for your position). I've used 20% decline thresholds for all of the names in the table below.
The Optimal Puts for FE
Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of FE against a greater-than-20% drop between now and October 19th. A note about this optimal put and its cost: to be conservative, the app calculated the cost based on the ask price of the optimal put. In practice, an investor can often purchase puts for a lower price, i.e., some price between the bid and the ask (the same is true of the other names in the table below).
Hedging Costs as of Tuesday's Close
The hedging costs below are as of Tuesday's close, and are presented as percentages of position values. The utility stocks below are listed in descending order of their trading volumes on Tuesday.
|(DUK)||Duke Energy Corporation||1.15%*|
|(XLU)||Utilities Select SPDR||2.35%**|
*Based on optimal puts expiring in October
**Based on optimal puts expiring in December