Strategy overview and why I hedge.
A position for consideration.
A brief discussion of the risks inherent to this strategy.
I hope that my articles provide insights to some investors who feel they need it!
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. Also provided in that article is 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 rarely 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.
Many of the series articles included varying views that I considered to be worthy of contemplation regarding possible triggers that could lead to another sizeable market correction at that time. Results from the hedging strategy were dismal during late 2016 and early 2017. By late June of 2017, I could tell that the bull market had much more life left than I had originally imagined. So, I decided to temporarily end the series until market and economic conditions were better suited for hedging.
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. But I do not hedge all the time. That would be counterproductive. 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. During 2015 and early 2016, my gains were much more significant, and I was able to offset all of my hedging costs for 2015, the remaining costs from 2014 and had plenty left over to extend my hedge well into 2016. So, my cost of hedging had fallen close to zero, and my portfolio remained fully hedged against loss.
Then for 2017, I found myself dipping into my cash again to cover the cost of my new hedge positions. As stated earlier, I realized that the bull was alive and well and let my hedges expire and stopped hedging.
As the market once again tries to move toward recent highs, I continue to hold my core stock positions (now at about 60%) for dividend income along with a large position in short-term bond ETFs (~30%) and the rest in cash. I may miss a portion of the current move higher, but I will not be distressed. As long as I miss the majority of the next big leg down, however large, I rest well knowing that I will keep my portfolio intact and have plenty of cash available to pick up the best companies at huge discounts. I can sell the bonds if I need more cash. I prefer to buy stocks at prices that I consider to be bargains relative to the value of the company. There is very little that meets my criteria in that regard in the markets today. Thus, I remain cautious and am beginning to hedge.
While I do not expect a recession for at least another year, I cannot dismiss the possibility, nor do I believe that all industries will hold up well during a prolonged trade war.
Fallout from the Trade War
It is my belief that China's economy will suffer more than that of the U.S. as a result of the escalation of the trade war. A month ago, I thought a negotiated agreement would be reached; now I am far less optimistic. China, it would seem, would like to drag things out and let things escalate as it believes that its citizens can tolerate more than the "weak" Americans. Its leaders may not want an agreement in hopes of getting a Democrat in the White House come January 2021. That is not meant to be a political statement on my part; I have read several pundits who believe a Democrat would be much more lenient for China.
It is my expectation that the reverse (that China will endure more pain) will be true. For more on my views on the coming pain and who suffers most, please consider "China Versus The U.S. - Who Gets Hurt." My reasoning, to summarize, is that China should experience the more lasting pain as many companies, especially multinational corporations, shy away from investing in China and move factories currently in China to other countries like Vietnam, Mexico or Indonesia where labor is still cheap. Some will build highly automated factories in North America to reduce labor and shipping costs.
Also, China stands to lose in terms of export volumes to the U.S. since higher prices will reduce demand or force U.S. retailers to source products from less expensive alternatives. The net effect is that China stands to lose millions of jobs, and its economy is likely to slow more than that of the U.S.
As far as who can outlast the other, the impact on the average household pocketbook is relatively small. Even if tariffs are imposed at 25% on all Chinese imports, the average monthly cost per household is likely to be less than $100 per month by my estimates.
According to a study mentioned in WSJ.com, American consumers are paying $1.4 billion per month on tariffs so far. With 127+ million households (according to St. Louis Fed), that amounts to about $11 per month in extra spending born by consumers. To get that number, I merely divided the $1.4 billion by the number of households in the U.S. It sounds like a lot until you do the math.
"Mr. Weinstein and his co-authors conclude Mr. Trump's tariffs have been fully borne by Americans, at a net cost to the country of $1.4 billion per month."
But the next round will include higher tariffs on more consumer goods. But not all the imports are for consumer goods. In the end, though, most things are consumed by someone as an end product somewhere. Some will be inputs for things we export. Hard to determine who will pay for those.
With 25% tariffs already on $60 billion and 10% tariffs on $200 billion, the $11 figure seems pretty insignificant. But, when the tariffs on the $200 billion move up to 25% and another $300 billion gets hit with 25% tariffs, my estimates of up to $100 per household per month (more likely around $90) seem reasonable.
A quick, back-of-the-envelope calculation could assume that most of the current consumer goods are in the current $200 billion of imports with 10% tariffs and, that if that number moves to 25%, the impact on households would approximately double to $22 per month. If the $300 billion that is not already exposed to tariffs were to contain three times as many consumer goods as the original $260 billion (a reasonable assumption), then the impact per household could be as much as an additional $66 per month. The total is about $88 per household per month. That isn't exactly how I go to my estimate of $90, but it is a way that is easy to follow and makes some sense.
If energy prices were falling, it would help reduce the impact since a $1 change in the price of gasoline can add or subtract about $54 per month per person (or about $135 per household) per month. When you compare the potential impact of the tariffs to the impact of a $1 change in the price of gasoline (which we have endured many times in the past), you get a better sense of how well the U.S. economy is likely to hold up. There will be pain, but it really isn't the end of the world.
A candidate to consider
I should point out that part of my strategy is to accumulate multiple positions over time that expire over the course of the next calendar year. I also try to hedge about 120 percent of the value of my portfolio. The reason I do is so that I can take gains on positions that are near to expiration (one to three months) when I have sizable unrealized gains available. I can only feel comfortable in doing so if I do not leave myself exposed by not being fully hedged after taking those gains. In January and February of 2016, I did not take gains of less than 300 percent on positions because it would have left me less than fully hedged. I watched those gains disappear back then, so I made an adjustment to the strategy. Now I can capture those gains because I have an excess of 20 percent that can be harvested to help hold down the cost of my hedging strategy until the next recession comes.
I will start with an explanation of the terms and abbreviations for those who may be new to the series. Symb means symbol, or ticker for the candidate stock; wherever [Curr] is used it means current; the target price is how low I believe the underlying stock may go if our economy falls into a deep recession; where I use [Prem] it represents the premium, or price, of the option for one share; each contract equals 100 shares; # of Cont means the number of contracts needed to protect approximately 1/8 of a $100,000 equity portfolio against a loss if the market falls by 30 percent or more; Est % Gain refers to the percent of gain for the positions relative to the initial investment if the candidate stock price falls to the target share price; Current Bid Premium is the last price at which the listed option contract was offered to be bought; Current Ask Premium is the last price at which the listed option contract was offered to be sold; the Target Premium is the price I will try to buy put option contracts for each of the candidates; % Cost of Port is the percentage of a $100,000 equity portfolio that will need to be spent to purchase the position as listed (plus commissions); and Exp Mo/Yr refers to the month and year in which the option contract listed will expire.
It seems likely that the one area of the U.S. economy that will be hurt is agriculture. China has (in the past few years), until recently, bought significant amounts of agricultural products from the U.S., especially pork and soybeans. As a result, prices have fallen for grains and pork. Profits are almost non-existent for farmers. It is very likely that U.S. farmers will plant fewer acres in 2019 and still lose money. That means that farmers in the U.S. are far less likely to buy new farm machinery.
Deere (DE) is a leading U.S. manufacturer of farm equipment and has suffered from such downturns in the past. I expect this time to be no different. If you look at the five-year chart for Deere, you will see that its price has been under $75 as recently as 2016. I believe it could easily get there again with another bad year ahead. The stock price has already dropped from a high of $169.99 to $134.82, a fall of over 20%, but I believe it has much further to go.
Curr Share Price
Target Share Price
Curr Bid Prem
Curr Ask Prem
# of Cont
Est. % Gain
Using DE as a hedge, I plan to buy two put contracts (for each $100,000 of equity portfolio value) that expire January 17, 2020, with a strike of $95 for a premium of about $1.68 per share. Each contract represents 100 shares of DE, so this provides a lot of leverage for a relatively small amount investment. The total cost should be $336 (plus commissions). If the broad market were to fall by 30% or more, this position is designed to protect 1/8th of a $100,000 equity portfolio against loss.
I don't think we need a broad market drop for Deere to fall, but I like knowing that I am protected. With the rising volatility due to trade issues this is a good time to be hedged. As you can see in the data file below (from Friedrich Global Research), free cash flow generation had already begun to deteriorate as of May 1st, even before the recent price drop.
Our algorithm supports an estimated fair value (Main Street Price) of about $98, but I think that will fall further in the months to come. Since Deere pays a dividend over $3 per share, I prefer to enter into a short position because that would make me responsible for paying the dividend for the borrowed shares. Shorting dividend paying stock can become expensive.
Discussion of Risk
I want to discuss risk for a moment now. Obviously, if the market were to rally higher beyond January 2020, my option contracts could expire worthless. I have never found insurance offered for free. I could lose all my initial premiums paid plus commissions. 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 the cost 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 to 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 (over several years) 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 often the case), the bear that follows is usually deeper than it otherwise would have been. In other words, there is a potential for the next bear market to be more like the last two. Anything is possible, but if I am right, protecting a portfolio becomes ever more important.
When the next crash does happen, I will be relying on a tool I found to be very useful in identifying the best bargains available at any given time. It is called Friedrich. I use it to highlight valuations in some of my other articles as I find it comes very close, in most cases, to my own valuation model results and takes me a lot less time. It is also going global, so I am excited about being able to scour most of the globe in search of value. When the USD finally does peak in value relative to other currencies, I will want to invest more of my portfolio carefully in foreign-based stocks to take advantage of the positive currency movements in the future. Value is value no matter where we find it.
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. Don't forget to hit the "FOLLOW" button at the top of the article next to my name to keep up to date on my next moves and full accounting of results for the strategy.
For those who would like to learn more about my investment philosophy please consider reading "How I Created My Own Portfolio Over a Lifetime".
At Friedrich Global Research, we stick to the numbers. We do analysis like what you saw in this article, but for 20,000 stocks from 36 counties around the world. We also provide model portfolios ranging from ultra conservative to aggressive growth, so you can apply our research to your investing easily.
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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in DE over 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.
Additional disclosure: DISCLAIMER: This analysis is not advice to buy or sell this or any stock; it is just pointing out an objective observation of unique patterns that developed from our research. Factual material is obtained from sources believed to be reliable, but the poster is not responsible for any errors or omissions, or for the results of actions taken based on information contained herein. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice.