By Scott Moses Murray & Mark Gomes
Recently, PTT Research Chief Analyst Mark Gomes issued a Stock Market Yellow Alert. These are fairly rare. We publish them when the market is frothy and excessively bullish or when it is showing signs of deterioration. The latter characterizes the market today. Paying subscribers received the alert on December 8th, one trading day after the S&P hit its all-time high. SPY has since fallen over 4%.
Our last article discusses the conditions that prompted Mark to issue the alert. Today we will discuss ways to hedge your portfolio to protect against loss.
According to the PTT Methodology, a Yellow Alert is a signal to go on the defensive. To do this, we keep the shares of official PTT picks and any other core holding we may have, but we protect ourselves by selling tertiary (non-important) holdings and putting hedges in place. To be clear, Mark does not recommend selling QAD Inc. (QADA), Mattersight Corporation (MATR), Glu Mobile (NASDAQ:GLUU), JAKKS Pacific, Inc. (JAKK), or Aero Grow International, Inc. (AERO). He remains bullish on each of these businesses and believes their shares are undervalued, regardless of market action. In fact, he was a buyer of MATR and AERO as the market tumbled. Even during a correction, any of these companies might be acquired for a large premium over its share price today. The entire market, meanwhile, will not be acquired tomorrow for a large premium. When the market is at risk, we sell the market. We have conviction in our core positions, so we hold onto them.
To protect our core positions when market risk is high, we put a full hedge in place. There are many ways to hedge. When you invest in PTT picks, you follow a strict Methodology. This is not exactly the case with hedging. It is more an art than a science. You have flexibility. It's not so important how you hedge, but it is important that you hedge.
To be fully hedged means for your hedges to have roughly the same beta-weighted value as your long positions. We won't explain beta-weighting in depth because you can look it up easily enough, but here is a brief version. Each of your stocks has a beta, its measure of volatility relative to the indices on which it trades. If you want to fully hedge a long position, multiply its dollar value by the stock's beta. The product of this multiplication is the dollar value you would short of the index (IWM, QQQ etc.) to create a full beta-weighted hedge.
Keep in mind that markets outside the US are also vulnerable. They make good hedges even if your stocks don't trade there. With that in mind, here are some hedges you may want to consider.
- Short SPY, which tracks the S&P.
- If you are uncomfortable being a short-seller, buy HDGE, an ETF which shorts the market for you and goes up when the market goes down.
- Short EEM, which tracks emerging markets. Emerging markets typically depend on foreign investment, which flees to safety when the market looks unstable.
- Buy UUP, which tracks the US dollar. A beneficiary of flights to safety, the dollar tends to do well when markets fall.
- Short FXI, an ETF that tracks China.
PTT subscribers are also shorting individual stocks that Mark's research shows have fundamental reasons to decline regardless what the market does.
A final word to the wise. This is not a Red Alert, but Mark believes conditions developing now may result in a fundamental breakdown in the market. He has issued only two Red Alerts in his career: one in 2000 and one in late 2007. A Yellow Alert is not a cause for panic. Three Yellow Alerts in 13 months imply that it is a time for caution, however. Mark plans to issue a number of market updates to PTT subscribers as events unfold, along with some picks that are Poised to Plummet-stocks that you can profit from by shorting. Visit us at www.pttresearch.com.
Disclosure: The author is long QADA, MATR, GLUU, JAKK, AERO.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.