A series of higher highs continue to define this May as the market pushes upward. The results of which are a maintained low cost of hedging. As of yesterday’s close the short-term daily cost was 0.70 basis points and the mid-term out to December dropped to 0.95 basis points per day.  

See data for the past 22 months on our Resources Page

Despite the S&P being 25 points higher now than where it was a week ago, the cost of hedging has ticked up slightly. The difference in the cost of hedging is minimal, but what is interesting is that it isn’t lower, as typically we’ve seen before.  Why you ask? I’ll share some insights on a discussion I had with one of our clients this week.
 
Imagine you have been long this market since December. That means you were bold enough to brave the worries of the fiscal cliff and held strong in the face of the sequester fears. Almost every day you would probably ask yourself if today’s new high was the time to sell. However you don’t want to try time the market and miss out on more of this run up. After all, you’ve been asking yourself that same question since the middle of March and you’ve been right to stick it out so far. However, you don’t want to be greedy and give it all back if there is a quick turn. So what do you do? The answer is you hedge.
 
Right now locking in gains with a hedge, vs. selling is a way to leave yourself exposed to the upside and limit how much you can potentially give back if the market turns south. The best way to lock in those gains is by buying long puts.  The cost of hedging at a level 10% below the market is 3.5% annually right now and this is the choice many investors are making instead of going to cash by selling. In other words, the worst you could do from here was to lost 13.5% if the market sold off by the end of the year.

However, if you want to tighten up those hedges, you can buy at the money puts for about 8% annually. They are more expensive than the 10% protection that cost at 3.5%, but if the market does correct, you keep even more of your gains for the year because you’re locked with the right to sell at these levels.
 
But there is also another factor that is keeping the longs long. It’s the taxable event of selling now. If you’ve been long for less than a year, the tax treatment is as short term capital gains, which is your income rate. Holding on to those gains for a year will yield a better return in your pocket after taxes by up to 20%. So ask yourself, does it make sense to pay 8% in hedging costs and stay long or sell now and incur a 20% higher tax bill? Before you answer, let me give you one more incentive to stay long…that is if the market does run up and your hedge never gets used, that 8% cost can be counted as a loss and carried over for when you do eventually sell. Convinced?
 
It seems right now, the answer continues to be stay long and hedge vs. selling and going to cash. This is a perfect example of the tail wagging the dog and how a good market can build on itself for no reason except is more efficient to stay long. 

As a financial services veteran of 20 years, I can attest that you learn a lot of ‘rules’ about the markets along the way. For instance, you learn that for a secular bull market to really get legs, the bears must capitulate and roll over to the bull side to fuel the market higher.
 
The problem with all of the rules that you learn is that they apply to what we would call ‘normal’ markets. I don’t know any analyst that thinks this is a normal market. In a normal market, interest rates are set by the market – and the result is that stocks and fixed income compete for attention from investors.
 
But this is not a normal market. The Fed has artificially forced interest rates near zero and is fueling a market bubble. In a market bubble, many of the normal rules don’t apply. So, through what lens do you examine and analyze the market? It is a difficult proposition.
 
However, a friend reminded me the other day that Bubble markets do have one rule that always applies: All bubbles eventually pop!
 
And this next comment might seem self-serving: since you don’t know when they are going to pop, you make sure you hedge your portfolio. In fact, because it is a timing issue, you must make sure to ladder your hedges. Laddering is when the protective puts that you purchase have different expiration dates.
 
If I were to enter a new hedged position today in the SPY, I would likely ladder using protection from December 2013, March 2014, and June 2014. And you roll the ladder forward as the near date expires. Then, with those regular dates spread out, if the bubble pops sometime, you will have protection at various levels based on how the market moved up.

Remember the rule ...

Although this isn’t one of those data points we track on a regular basis at Buy and Hedge, I saw an interview on CNBC that made me pay attention. It basically illustrated that home ownership rates in the US continue to decline.  Here’s the chart that peaked my interest:

Most of the interview was about lending standards and credit score requirements. However, on a personal level, this topic hits close to home, as I’m in the process of moving and buying a new home. Here is the interview if you’re interested: CNBC Clip Link

After seeing this, I pulled up the latest Department of Commerce report from April 30th on the subject.  Here is the link to the full report. Residential Vacancies and Home Ownership Q1 2013

The data shows that indeed we are at the lowest levels of home ownership in the US since the 3rd quarter of 1995. This downward trend exists in spite of the general trend of dropping housing prices and rising rental rates.  Oh yea, add to that historically low mortgage rates driven by the Fed QE programs.

We’re all familiar with the notion that recoveries are led by real estate rebounds. This is some of the reason why the Fed is so active in keeping interest rates down.  But what surprised me most was the apparent lack of impact it has had in home ownership since the peak in 2005. After seeing this, I’m not sure why many think the bottom is in on the housing market. I understand prices are turning in recent months, but it seems to me that it will take a migration of the renters to become owners to move the needle here significantly, and that trend is only going down. 

I really like this article from Econbrowser about the overall S&P500 market valuation. You should read it.
 
To summarize:
The stock market is approaching valuation ranges that are high relative to historical comparisons – but not higher than we have ever seen before. See the chart:

Probably more importantly, what happened to your money if you invested in the market at a time when it was higher than the historical norms by a material amount? Your 10 year returns would have lagged or been negative in many of these scenarios.

The overall problem – while this might show a market ready to produce negative returns, fixed income is not a safe haven for you so what do you do?
 
YOU HEDGE!!

I’d like to introduce everyone to an index that has been around since 2008, the CLL. CLL is an index designed to illustrate how a hedged portfolio using long puts and short calls will perform. It is a benchmark that few people know about, but essentially follows the collar strategy on a theoretical S&P 500 collar position. You can enter that into any of your stock charting tools to see its performance over time.
 
As a reminder, a collar is a tactic designed to protect a long position by purchasing puts as protection and pays for it by selling calls. These two option positions limit the performance of the long position to stay within the strikes of the put and call. There is still usually a price for this protected position, but will provide a portfolio of lower volatility and limited losses. Here is an example of a Profit-Loss chart of a collar:

The CBOE has created a micro-site to outline the process used to create the index, so here is the link: CBOE CLL Micro-Site

 
Here is the tactic used to create this index

• Hold stocks in the S&P 500
• Buy a 3 month SPX put 5% below the market
• Sell a 1 month SPX call 10% above the market

 
This index is referred to as a “95-110” because of the levels of protection and upside limitation. Said another way, the index is designed to limit losses to 5% (95% of holdings) and restrict upside movement to 10% (position stops gaining value at 110% in a single month).
 
As with most hedged strategies, the CLL lags in up years and outperforms in down years. For example,  in the past 12 months CLL has gained about 12% while the S&P 500 is up 20%. 

If you’re hedging, this is an interesting benchmark to use to tell if the complication you’ve added to your portfolio is worth it, or if just following this very basic tactic ends up doing better.