Education Newsletter

With flash crashes, high-frequency trading, and global credit crises, it is no wonder that investors are gun-shy in today's stock market. Part of that fear can be alleviated through hedging for specific events, but is it possible to stay protected at all times?

Short-term put buying is often the best way to hedge a long equity portfolio amid the vagaries of earnings and other anticipated catalysts. In this volatile environment, however, some people are looking for ways to shield their investments from unforeseen consequences as well.

In these cases, longer-term puts can make sense, up to a point. Many traders buy six-month puts and then sell them with maybe six weeks before they expire to avoid the most time decay eating into premiums. Using puts in indexes or exchange-traded funds, such as the SPDR S&P 500 Fund (SPY), can be a good alternative to contracts in individual equities for protection against broad market drops.

In theory, having the direct protection that puts afford allows investors to sleep well at night and not worry about the inevitable, if infrequent, downside shock. But life is not so easy.

Hedging is clearly a drag on performance. Puts, especially those in the indexes and their ETFs,  are notoriously expensive. Many studies have been done about the so-called implied volatility premium, which results from put sellers requiring a premium over actual volatility to compensate for the risk they take.

In this regard, the CBOE has done us a great service in the various indexes it has created and maintained. The most useful in this case is the CBOE S&P 500 PutWrite Index (PUT), which consists of selling one month at-the-money puts.

The PUT index has a return of 1,153 percent from mid-1986 to the end of 2011 compared to a return of 807 percent for the S&P 500, according to the CBOE. And the PUT did it with 30 percent lower volatility in a period that included the crash of 1987 and the 2008 crisis.

So owning puts all the time against your long stock may not be such a good idea, especially if they are index puts that are only one month out. One way to mitigate some of that cost is to use collars--selling calls to offset the cost of the puts. And there is an index for that too.

The CBOE S&P 500 95-110 Collar Index (CLL) holds the S&P 500 stocks, buys three-month puts at 95 percent (of the SPX value), and sells one-month calls at 110 percent. Unfortunately, its long-term performance is quite bad.

From the end of June 1988 through the end of 2011, the CLL had an annualized return of just 6.1 percent, compared to 9.1 for the SPX and 10.8 for the PUT. The standard deviation (a measure of risk and volatility) was 10.8 percent for the CLL, less than the SPX's 15 percent but above the PUT's 10.2 percent. So collars may not be the answer either.

Constant hedging clearly has its costs, and they simply appear to be too high to sustain. Academic studies have been done about the costs of perennial protection--especially as "tail risk" hedging has gained in popularity--and most of them conclude that such hedges aren't worthwhile, especially if we don't get another 2008-type crash in the near future.

Put buying or using collars can be a great way to hedge, but they are best used tactically instead of constantly. Next week we will look at other solutions to the hedging conundrum.

The Financial Times ran a story of profound importance last week, but few noticed.

It reported that brokers including Merrill Lynch believe that stocks are becoming safer long-term investments than government bonds. This corresponds with some of my own research and helps explain recent price action in the S&P 500.

It's difficult to express what's happening because I believe that we are nearing a true paradigm shift in the world of finance and investing. Attempting to make specific predictions is a fool's game, but certain factors are lining up in a way that suggests we're near the beginning of a new bull market. It will have its own causes and attributes that will unfold over a period of years rather than months.

Put simply, I believe that stocks are underowned and that Treasuries are overowned. We are nearing a point where the marginal dollar will increasingly flow into equities over bonds and where money will gradually migrate away from "safe assets."

First, it's important to realize that Treasuries have enjoyed the greatest bull market in history since 1980, with yields consistently ticking lower in good times and bad. They now seem to be near levels where they can fall no further. (The Fed can't push rates much lower, and the 10-year Treasury yield seems to have formed a double bottom in the last two months.)

Second, government bonds are now showing all signs of a bubble in its final stages, with people plowing money into them indiscriminately. Supply has surged in response--just the same as Latin American debt in the late 1970s, dot-com stocks in the late 1990s and residential mortgages in the middle of the last decade.

Third, assets similar to Treasuries have already started to fail. Remember Fannie Mae and Freddie Mac? Also, look at sovereigns in Europe and municipalities in California. Mortgages are another case study because they had been and supported by the federal government since the 1930s. Roll back the clock 10 years, and none of those assets were priced based on credit risk; they were based only on interest-rate risk.

In some ways, the crises of the last five years resulted from nothing more than the market waking up to the credit risk in mortgages and sovereign debt. But that consideration of credit risk has not yet been applied to Treasuries. How many investors, after all, analyze the creditworthiness of the U.S sovereign before buying bonds? (Answer: None.)

There is no denying that U.S. public institutions have become increasingly weak--just look at the state of Congress and the budgetary process. In the last decade, government spending has surged to about 140 percent of revenues from 110 percent while total debt has almost tripled.

In the same period, companies have done the exact opposite and grown increasingly strong. Their profits have risen from 3 percent of GDP in 2002 to more than 8 percent now, and they're better capitalized than at any other time since World War II.

In fact, a longer-term view is important because the 20th century was a period of powerful governments and weak companies. The trend started during the Great Depression and continued during WWII and the Cold War, when the state in various ways promoted innovation and investment in such areas as aerospace, medical research, and technology.

But we must never forget that modern capitalism actually began in the 19th century. That's when companies and private individuals ruled the world--there were no Treasuries.

Something similar seems to be taking shape again. It doesn't mean to chase stocks at the highs, but it does mean to buy the dips and enjoy the ride.