By Nicholas Colas, former Portfolio Manager At SAC Capital and creator of DataTrek Research
Happy as we are that US and global equities have found their footing in the wake of the March 8th/14th lows, we also want to keep a level head about what may come next:
- The setup for this rally was a deeply oversold market, exemplified by the CBOE VIX Index close of 36.5 on March 7th. That, as we have mentioned many times even before this month, is 2 standard deviations from the long run VIX mean (20).
- It would have been very unusual if we had not rallied after the VIX hit that level.
- In other words, we’re relieved our VIX +36-level strategy worked but are not conflating that with any real change in market dynamics.
This week’s Story Time Thursday, therefore, is about hedging: how to consider potential market risks and develop investment strategies to offset their impact. I (Nick) have used the story about a fire in my apartment building to kick off this topic before, but here is a quick refresh and its key lesson.
In the middle of a March night 4 years ago, my wife and I woke up to the sound of smoke alarms going off across the entire floor of our building. Someone banged on our door, yelling “Fire!”. This was the real thing, not some random cooking mishap.
We quickly got dressed and grabbed our go-bag. That knapsack is what usually gets people’s attention when I tell this story. Yes, I have a carefully assembled set of items in a bag sitting in the closet by the front door. It has everything from emergency blankets to walkie-talkies and a full first aid kit. It also has a lot of cash in small bills, our passports, and other sundries.
Within 3 minutes, the smoke had filled our apartment and it was impossible to breathe. I crawled out and into the hall. (Note: If you hear a fire alarm and smell smoke, do not dawdle. Smoke moves very, very quickly).
We walked downstairs and went outside, where we found all our neighbors – a good +100 people – standing in the cold in their pajamas and robes. Fortunately for them, other buildings in our complex were safe to enter and they were able to get out of the elements quickly. The fire department came, and after a few hours they put out the blaze. Thankfully no one was hurt.
The lesson from this story: predicting what other people will do during periods of heightened uncertainty is the key to effective risk management and hedging. I was very surprised to see that none of my neighbors had thought to get dressed and certainly no one else had a go-bag. At one level, I suppose that makes sense; the average person rarely needs to leave their home in a hurry. But on the off chance one does have to make a hasty departure, it does pay to prepare at least a little. No one was. That’s part of why markets drop so quickly during a crisis: lack of preparation/hedging.
Now, just like you cannot plan for every contingency in real life or afford to protect yourself from every possible negative outcome, you must also choose what sorts of hedges you want in a portfolio of financial assets. Here’s how I think about that:
#1: Hedges come in two flavors: absolute and relative. The first makes money in a crisis, the second just loses less than most other options. Absolute hedges are rare because, during a shock, financial asset price correlations go to 1.0 pretty quickly. Even gold lost money in 2008 – that’s how bad the Financial Crisis was.
To my thinking, 10-year Treasuries are the only true absolute crisis hedge in financial markets. Sudden shocks create uncertainty, and that drives capital into long-dated Treasuries. Could there be a crisis where this does not happen? Sure. But I’m pretty sure I would not want to be around for it.
#2: There are 2 sorts of negative events most investors are thinking about when they say they want/need a hedge:
- The first is a specific event that creates substantial near term volatility. The 1973, 1979 and 1990 oil shocks are good examples. So is the 2020 pandemic.
- The second is a long period of either stagnant or declining real returns from a major shift in the investment climate. Many investors are concerned that we are about to see a repeat of 1970s stagflation and want a hedge against losing purchasing power, for example.
These are 2 very different scenarios, and we’ve found that market narratives tend to swing between them even though both are always valid concerns. Right now, inflation hedges (US stocks, gold) are in vogue. That’s understandable, but we should remember that oddball exogenous shocks can still happen. Underweighting long-dated Treasuries makes sense just now, but we’d still own 5-7 year US sovereign debt as a partial crisis hedge.
#3: Sometimes the best hedge is to NOT own an asset. A lot of investment commentary related to hedging focuses on what stock, sector, commodity, or bond duration to own for a given adverse scenario. But … It is just as productive to consider what will do poorly.
Simple example: say you want to hedge recession risk in a US stock portfolio. One approach would be to underweight small cap stocks by owning the S&P 500 rather than the Russell 3000 or another all-market cap index. A recession will cause tighter financial conditions, something that always hurts small cap stock returns. If the recession comes, you should outperform. When it ends, small caps will be worth owning again.
Summing up: try not to overthink things, and that advice applies even more for risk hedges. Consider which risks concern you most, and focus on those. There may be no such thing as a percent hedge, but “good enough” can go a long way