Wednesday, October 22, 2008

Coping With Challenging Markets By Hedging Your Bets: Financial and Personal

Dear Readers,

It really has been an amazing time; I've traded the equity markets since late 1977, and I've never seen market and economic conditions like these. It's not just the ferocity of the decline: it's also the extended high volatility and the way that so many of the major asset classes: commodities, bonds, and stocks have been hit hard--and simultaneously. Add that to the decline in housing and more general concerns over recession and you have bearish sentiment that feels qualitatively different than at prior market drops. Polls show that the vast majority of Americans feel dissatisfied, convinced that the country is headed down the wrong path. Confidence in Congress and the White House is at all-time lows. Consumer confidence has tanked.

Traditional logic says that such pervasive bearishness should lead to favorable market returns going forward. After all, who's left to sell when everyone is bearish? In normal times, that logic holds. Although I'm currently working with a scenario of stock market bottoming and an eventual intermediate-term rally, I'm not sure the traditional logic makes for sound investment policy. At some point, qualitative differences yield quantitative ones: when negativity is pervasive, it affects future decision-making, with self-fulfilling effects for the economy. That's what we saw at important secular market bottoms in the 1930s/1940s and in the 1970s/early 1980s. Undervalued markets stayed undervalued for an extended time; bottoming took years.

That doesn't mean that civilization as we know it is over, that we will replay the Great Depression, etc. It does mean, as my friend Henry Carstens observed, that we're moving from a leveraged world to a deleveraged one, as credit is unwound throughout the financial system, from banks to homeowners and consumers. It's a bit like getting off amphetamines: there's quite an initial crash. Leverage has pumped up home sales, profits, real estate development, and consumer spending--and now deleverage is winding those down. Valuations from a leveraged world are transitioning to deleveraged valuations. In my personal financial planning, I'm assuming that such a transition will not occur in weeks or months. I am prepared for the possibility of subnormal stock market returns for years to come (just as market returns were subnormal following the massive declines of 1928 and 1974), and I am prepared for the scarcity of credit to keep corporate and municipal bond yields high for an extended period.

In times of stress, we tend to anchor our thinking in the most salient pieces of information; behavioral scientists refer to this as the availability bias. When volatile markets rise, we hear talk of "the worst is behind us"; when they fall, we hear of repeats of the 1930s. Worse still, financial planning--even among supposed professional financial planners--becomes simplistic: either hold on and wait for the turnaround or bail out of everything and rescue what capital you can. Little wonder that so many investors are frozen, not knowing whether to stay the course or jump ship.

Prudent investment planning, however, suggests that neither extreme is necessary. The important consideration is identifying which assets (stocks, bonds, etc.) are likely to outperform the general markets during any period of extended weakness and ground investment in those. Then, hedge your bets. If you think that some companies that offer value to consumers--or that offer necessities--will outperform those that do not, you can be long the attractive names and short the unattractive ones. Or you can be long the attractive names and short the broad stock market. You hedge your bet by reducing your exposure to overall market risk. Your investment becomes a relative value play, rather than an outright directional one. I almost never hear financial planners talk about that, and I almost never hear of such strategies from the general investment public.

Recently, in my investment accounts, I've been long some high-grade, insured municipal bonds and short stocks. My bonds have declined in value; my short position in stocks has helped compensate for that. Meanwhile, I collect the "carry": I make more in yield from the bonds than I pay out financing my short stock position. That's a kind of hedge (albeit not a perfect one). I'm looking for relative value, not just absolute market movement.

In difficult markets, there are always areas of relative opportunity. You might be long the U.S. and short some vulnerable emerging markets; you might be long gold and short base industrial metals. Getting away from availability biases and thinking multidimensionally is an excellent coping strategy for difficult markets.

That having been said, one antidote for abnormal markets is to ground ourselves in normal, daily life and the things we can control and enjoy. I've cut back on business travel and will be taking some extra family time in weeks ahead. I'll be getting back to editing my new trading psychology book and writing my free e-book. When you're hedged and can sleep with your portfolio, it frees you up to enjoy what's most important in life. And, psychologically, those important activities--whether they be family, writing, or other personal pursuits--are the best hedges of all, the most valuable sources of diversification.

Thanks as always for your interest and support--

Brett
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12 comments:

onionfutures said...

Dr Brett, a quick question, has the current markets 'weirdness' and volatility caused you to make any changes to your book? Are you looking to reflect the current mood and use its uniqueness to pass on some psychology ideas that before the markets movements you didn't have planned?

The Financial Philosopher said...

You are correct that the conventional investment advice, such as "buy & hold," diversification and dollar-cost averaging are a bit difficult to swallow right now.

But I respectively submit to you that it would be potentially more damaging to say "it's different this time," as the tone of your post suggests...

The core problem we all face is that we place too much value on money in the first place. I find it to be almost embarrassing to see images of traders with worried looks on their faces on the covers of newspapers and magazines around the world.

Are there not more important things we can focus on? How's your kid doing in school? Is your family healthy? Do you have food, shelter and clothing? How do you define success, wealth and happiness?

Perhaps this is not the time to reflect on the financial challenges of the times but to reflect on what truly brings meaning to our lives...

"Ever more people today have the means to live, but no meaning to live for." ~ Viktor Frankl (1905-1997)

zircon-212 said...

financial philosopher....I read the article as Dr. Brett saying be proactive in this environment rather than rely on the ostrich trade of sticking your head in the sand. It is all nice and dandy to think about all the great things you have in your life other than ones rapidly depreciating wealth, but this does not and will not stop money that you have at risk from becoming worth even less. Everyone has an 'uncle point' and you do not want to passively reach that point in your trades or investments.

Mark Wolfinger said...

"I almost never hear financial planners talk about that, and I almost never hear of such strategies from the general investment public."

Financial planners are not competent to handle anything more strategic than 'diversification,' IMHO.

And who's going to educate the public to ask the right questions? There is no one.

We are making that attempt via our blogs, but the masses are under-informed. That's a shame.

Best regards,

journeyman said...

Dear Bret,

I am reading your blog for past few days and i would complemet you for giving great advice.I am very young and inexperienced in trading but have developed some liking for it. Reading guys like you helps me a lot as i learn from your wisdom.

But i have my doubt as regards this article which asks us to be more proactive towards finding opportunity while hedging for market risk. The issue is very simple, leveraging is risk and the whole world is reducing risk right now. Suppose i do a trade right now say long gold and short base metals and it goes the other way round i lose money both ways instead of being on cash. So why should i look for opportunity when it is coming at huge risks we are witnessing today ( you would agree with your experience that trading today has more than average risk). Also by trying to hedge its possible that we might not be able to hedge risk completely, in that case i am still taking atleast some risk. So lets say my call goes right and i earn some money it will be less than what i could have earned had i carried only one part of the trade( i.e. lets say just went long gold or short stocks by using money i was puting in bonds).
So my dilemma is why to hang in between where earning potential seems low than risk taken. Rather we should take risk fully and earn a lot or we should not take risk at all.

In case if you find time please clarify.

zircon-212 said...

journeyman...long gold and short base metals is NOT a hedge. Maybe you are looking for a 'texas hedge' like TB Pickens seems to be good at....long the underlying crude futures as well as owning the black gold being pumped out of the ground. Dr. Brett is not talking about trades or positions that are for the newly initiated or those still playing farm ball. A favorite street saying is 'with risk comes reward'...sometimes taking risk off and sitting in cash is your reward, but at the same time there are huge opportunities out there every day. If you are a 'trader' and unable to make money in once in a lifetime opportunities like we have now I suggest hanging up the cleats and focusing your efforts on another endeavor.

weightoftheevidence said...

Brett:

If you have a cost of carry as you mentioned on your shorts (beyoud dividends), you are getting shafted by your broker .... I assume you accidentally misstated.

CM said...

Dr Brett, I have a question.

>> I've been long some high-grade, insured municipal bonds and short stocks. My bonds have declined in value; my short position in stocks has helped compensate for that.

If you are long X and short Y, does it not limit your returns? Also, if gains in long X are offset by loss in short Y, then what is the point of a hedge?

Thanks for your comments.

CM said...

Dr Brett, I have a question.

>> I've been long some high-grade, insured municipal bonds and short stocks. My bonds have declined in value; my short position in stocks has helped compensate for that.

If you are long X and short Y, does it not limit your returns? Also, if gains in long X are offset by loss in short Y, then what is the point of a hedge?

Thanks for your comments,
CM

qew said...

Very nicely written blog. Thank you for sharing your thoughts.

Can you share with us what vehicle you are using to long high-grade, insured municipal bonds ? I have been trying to find a good vehicle to do that.Thanks in advance.

Joshua said...

Regarding the "it's different this time" theme:

There's always the exception that proves the rule. Also, it makes sense that a bear market WITHIN a secular bear market would be particularly violent and extend further downward than expected before the anticipated bear market rally. Or it might "correct sideways through time" and then continue its downward trend.

----

"the way that so many of the major asset classes: commodities, bonds, and stocks have been hit hard--and simultaneously"

Dr. Brett,
Are you familiar with the inter-market analysis work of Martin Pring? He separates the economic cycle into 6 different stages.

1. only bonds bullish
2. only stocks & bonds bullish
3. everything bullish
4. only bonds bearish
5. only commodities bearish
6. everything bearish

I think its safe to say we are in stage 6, and should be looking for stage 1 (bonds bullish) to begin. With the flight to safety, conditions are probably ripe for a bottom to occur in at least the safest bonds (i.e. Treasuries).

As a historical reference, Mr. Pring gives past dates for the start of stage 1 as October 1981 and June 2001. Of course, his framework is only a guide and the stages don't always perfectly take their expected turns.

Anyway, his book "The Investor's Guide to Active Asset Allocation" breaks down which industries do the best during different parts of the credit/economic cycle. I think it is a great longer-term look at the fundamentals of inter-market relationships. I highly recommend it.

Joshua said...

"The important consideration is identifying which assets (stocks, bonds, etc.) are likely to outperform the general markets during any period of extended weakness and ground investment in those."

Dr. Brett,

Have you ever thought of your shorter term trading as an asset class?

Perhaps with high volatility and your experience as a trader, a bull market in trading has arrived! :)