Treading Lightly: Hedging the Market With 2 ETFs

Includes: RWM, SH
by: Joseph L. Shaefer

"I’ve got my Hush Puppies on

I guess I never was meant for glitter rock and roll

-- Jimmy Buffett, 1974

I put my Hush Puppies on when I want to tread lightly. Now, I don’t know how the market is going to open on Monday – and neither does anyone else, especially those who scream the loudest that they do know. What they are banking on is that when they’re wrong (most of the time?) you’ll scratch your head and say, "Now who was that idiot? I forget." But when they’re right (once in a blue moon?) you won’t forget it. They won’t let you.

The only honest answer to "What’s going to happen?" is: "It depends." Or, as J.P. Morgan once famously dodged, "It will fluctuate." It depends on whether more or less radiation leaks from the Fukushima reactors; whether the winds carry that radiation, if it exists, south to Tokyo or east over the Pacific; whether there are signs that Japan will recover from the earthquake and tsunami (a news story lost in the minute-by-minute watch over the radiation being emitted, a far more riveting story for TV) more quickly or less quickly; whether Gaddafi will honor the cease fire he proclaimed (and broke as he was proclaiming it); whether the no-fly zone will be effective; whether a SAM gets a lucky shot and downs a U.S. or NATO pilot; what will happen in Yemen, Bahrain, Oman or another Mideast nation in the next 48 hours; and a thousand other variables that can change in a nanosecond.

What doesn’t change in a second, however, is The Big Picture. And while I am unwilling to sell the great companies we hold in client portfolios in order to nail down a profit – but risk missing re-entry as/if volatility increases – I am very willing make that "committed" to protect what we currently have by hedging our positions. If I hedge at 100%, we create a neutral position where we accept that we make nothing in a rising market but lose nothing if it opens down 300. If I hedge at something more like 50%, which we are doing for our more conservative clients, we reduce our downside by only 50% but still participate in any upside, at least to the same degree.

There are a number of ways to create such a hedge. Cash is the best. Having 50% of our powder dry means it is in reserve for what we consider a better time to enter the fray. Market up or market down, the cash doesn’t fluctuate. Another way is to write covered calls on our most-profitable positions, thus ensuring we participate at least to the extent of the call price plus the premium received if the market goes up, and we reduce our basis by the amount of the premium received if the market goes down. Since not every client wants an options account, the way we most frequently protect them is to simply buy shares in inverse (not leveraged inverse) ETFs. Here’s why I think that makes sense now.

Too many investors see this pullback as just another buying opportunity. That kind of complacency may seem impossible given what happened less than 3 years ago, but it is true nonetheless. Abetted by wildly optimistic underwriter reports like Credit Suisse’s call for Apple (NASDAQ:AAPL) to hit $500, and inured by markets that have climbed a wall of worry since March of 2009, it seems no one believes even a 10% retracement back to the 200 day moving average, which I’ve been calling for, is possible.

Mine is hardly an outrageously bearish proposition. Brazil, India, China, and Hong Kong are all down double-digits from their highs. Most markets in Europe are down, though not as much. The U.S. has not yet sustained a correction this year of more than even 5%. (It was down 6.3% a couple days ago, but buyers quickly stepped in, buying tech, banks and the other usual suspects.

In addition, central banks are tightening credit and raising rates in the four "emerging market" nations mentioned above and in others. Inflation is on the rise globally – worse, it is on the rise in basic foodstuffs, where emerging populations often spend as much as 50% of their income. Most investors have conveniently forgotten the debt crisis/labor crisis/work ethic crisis/demographic crisis in Europe. Having just returned from there, I can assure you that just because it is on the back burner does not mean it can’t boil over!

Add to these the inevitable cutbacks in U.S. federal, state, and local government spending as they attempt to bring their deficits under control, the end of the Fed’s money-printing, pump-priming program ("QE2") and, of course, the seething cauldron that is the Middle East, upon which Japan, Europe and to a lesser degree, the rest of the world depend upon for a stable flow of essential oil. Finally, you don’t shut down the world’s 3rd-largest economy (which I imagine will be, temporarily, #2 for a short while again if China’s real estate market implodes) without global supply-chain ramifications.

I don’t suggest the markets can’t climb a wall of worry for another year. I merely point out that this bull-cycle, unlike the spring of 2009, is rather long in the tooth to be able to continue vaulting up walls, Worry or any other kind. So we are taking some profits and leaving the proceeds in cash; buying contracyclicals, particularly in agriculture and energy; writing covered calls for those clients willing to do so; and buying leveraged options.

If you want to hedge "the market" one easy way to do so is to buy the ProShares Short S&P 500 ETF (NYSEARCA:SH). If you believe one sector of the market may be weaker than another, as we do, then you might want to drill down a bit. In our case, we believe the small caps of the Russell 2000 have had the biggest run and got the furthest away from their respective 200-day moving averages. The way we are hedging by shorting this group is to buy the ProShares Short Russell 2000 ETF (NYSEARCA:RWM). We are less interested in eating even better this month than we are in sleeping well every night. A combination of cash, covered call options, and inverse ETFs allows us to do just that ...

Disclosure: We, and/or those clients for whom it is appropriate, are long SH and/or RWM. We also have a good cash cushion, some covered calls, and tight trailing stops in place. The Fine Print: As Registered Investment Advisors, we see it as our responsibility to advise the following: we do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as personalized investment advice. Past performance is no guarantee of future results, rather an obvious statement but clearly too often unheeded judging by the number of investors who buy the current #1 mutual fund only to watch it plummet next month. We encourage you to do your own research on individual issues we recommend for your analysis to see if they might be of value in your own investing. We take our responsibility to proffer intelligent commentary seriously, but it should not be assumed that investing in any securities we are investing in will always be profitable. We do our best to get it right, and we "eat our own cooking," but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.

Disclosure: I am long SH, RWM.