It’s back to Fantasy-land investment markets, right?
With the Dow hitting new highs yesterday and the emerging markets seemingly heading to Mars, it might be an opportune time to talk about portfolio hedging. Amazing, but despite horrid earnings for UBS of Switzerland (NYSE-UBS) and Citigroup (NYSE-C), both stocks rallied amid Monday’s euphoria. What’s going on here?
Historically, the fourth quarter is the strongest three-month period of the year to be invested in common stocks. And as I pointed out earlier last month, that includes strong returns even during the last secular bear market. Whether you like it or not, we are still in a bull market in late 2007 and that means we’ve got even higher to go, barring some exceptional financial time-bomb still lurking out there.
Stocks have already discounted the worst of the sub-prime and mortgage-backed crisis. Markets look ahead and if the banking sector is rallying, it’s because participants don’t think the bad news will get any worse. After all, banks have set aside provisions to absorb this pesky sub-prime mess and the Fed has started cutting the monetary spigots to alleviate credit stress.
But despite powerful historical anecdotes pointing to higher markets ahead this quarter and lower interest rates, I am still hedged. I’m never fully invested because I always like to be in a position to buy – that’s something my step-father taught me years ago. Believe me, it’s totally untrue that an investor must be fully invested to beat the markets – what counts is your asset allocation or mixture of stocks, bonds, currencies, commodities, cash, and alternative investments.
So if you’re not feeling too confident about pouring everything into stocks, and I’m not, consider buying some Japanese yen, a reverse-index fund on the Russell 2000 Index and some commodities. And, of course, you should have some cash handy.
Below is a 12-month chart of the Russell 2000 Index of small stocks. I like betting against this index now because it’s highly cyclical; in a slowing economy, smaller companies are more vulnerable to a major decline than large-caps, a transition that has already occurred.
A maximum 10% allocation to a reverse-index fund is sufficient. Combined with Japanese yen – highly negatively correlated to equities, cash and some commodities, you should be able to shield your portfolio.
Hedge funds, generally, don’t do a good job protecting assets in a protracted market decline. Hedge funds, however, have done a good job in bear markets, but only if the trend is long-lasting and managers can easily identify trends. Otherwise, the sector gets a big F in my books.
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