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--