S&P 500 Index 1776
By Steve Blumenthal
October 30, 2013
Trade Signals is designed to help you navigate the risks and rewards of the stock market. I believe a less certain investment outlook is ahead due to unmanageable debt, entitlements and unprecedented central bank manipulation. Debt deleveraging cycles are different than re-leveraging cycles. Required today is some form of risk mitigation. Fortunately, there are relatively inexpensive ways to protect your important long-term equity exposure.
Included in this week’s update:
- Sentiment Charts – Extreme Optimism: Establish Risk Protection Today (i.e. hedge long equity exposure)
- Cyclical Bull Market Charts – The cyclical bull market trend is aged but remains favorable.
Investment Sentiment charts 10-29-2013:
Sentiment Chart 1. NDR Crowd Sentiment Poll – Extreme Optimism: Establish Risk Protect/Hedge Long Equity Portfolio Exposure
Sentiment Chart 2. NDR Daily Trading Sentiment Composite – Also in the Extreme Optimism Zone.
Cyclical Bull or Cyclical Bear Market Trend Charts – Both Trend Charts Remain Bullish
Cyclical Trend Chart 1: 13/34-Week EMA – Note the blue 13-week EMA line remains above the red 34-week EMA line. Also note how well this simple, tactical indicator has historically captured the cyclical bull and bear market trends. Signals occur when the lines cross.
Cyclical Trend Chart 2: Big Mo remains in a Cyclical Bull trend
How the Economic Machine Works – Ray Dalio
Summary
Investor Sentiment has moved back to Extreme Optimism. Risk protect (hedge) long-term focused equity portfolio exposure today. I discuss a collared option strategy below. Consider out of the money put options and/or inverse ETFs. Put options offer relatively inexpensive risk protection.
The cyclical bull remains aged. Market valuations are relatively overpriced (Median Fair Value at 1420 according to NDR Median PE calculation) yet the cyclical trend remains bullish. The S&P 500 Index will be overvalued at approximately 1850. This represents a one standard deviation move above Median Fair Value.
I am carefully watching for a change in trend. I favor the two charts above and will recommend a far more conservative posture towards equities when the 13/34-week EMA chart or Big Mo indicate a regime change from Cyclical Bull to Cyclical Bear.
Look to remove hedges when Investor Sentiment moves back into the Extreme Pessimism zone (I favor the NDR Crowd Sentiment Poll as I’ve relied on it for years; however, others favor the Daily Sentiment Poll. Both charts are useful.).
I believe that risk is elevated based on a modestly high PE multiple, current low dividend yields, low inflation and low interest rates. Further, the macro picture remains challenged due to unmanageable levels of debt, unmanageable entitlements and unprecedented market manipulation from the world’s global central banks.
To me this is a period that requires a risk protection game plan as it relates to your long-term equity exposure. I favor putting protection in place at points of extreme optimism. Investor Sentiment may serve as a useful guide. Highly manipulated markets are anything but normal and I think the risks today are greater than they were prior to the 2008 meltdown. One has to have a proactive plan in place to manage portfolio risk until we reach a more favorable investment environment.
If you are a more conservative investor, look to own deep out of the money put options for market crash protection. We are in interesting times.
If you are unable to actively hedge with options, I have an idea for you to consider in your equity bucket as my macro belief is that there is a significant correction coming ahead:
We recently launched the CMG Global Equity Strategy, which selects 50 well known companies based on a culture of exceptional leadership as measured by strong balance sheets, income statements and a consistency of delivering strong earnings growth. The objective is to own these solid stocks for a year and then re-rank and invest in what we believe to be the top 50.
Additionally, we hired Dr. Andrew Lo and his team from Alpha Simplex to run their volatility risk management strategy to protect the equity exposure from time to time. The goal is to have excellent equity exposure with built-in disciplined risk management (risk management: as measured and managed by Dr. Lo and his team).
Instead of having to actively manage the equity risk within your portfolios (trading options or some other approach), this may be a good solution for you to gain important long-term focused equity exposure coupled with built-in risk management. You should Google Dr. Lo. He has an impressive background. There is certainly no guarantee that Dr. Lo and his team get the risk protection correct but I believe such an allocation may be an important diversifier within your equity bucket.
Call your CMG advisor representative if you would like to learn more.
Wishing you the very best.
With kind regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
steve@cmgwealth.com
610-989-9090 Phone
For hedging, I favor a collared option approach (writing out of the money covered calls and buying out of the money put options) as a relatively inexpensive way to risk protect your long-term focused equity portfolio exposure. Also, consider buying deep out of the money put options for risk protection.
Please note the comments at the bottom of this Trade Signals discussing a collared option strategy to hedge equity exposure using investor sentiment extremes is a guide to entry and exit. Go to www.CBOE.com to learn more. Hire an experienced advisor to help you. Never write naked option positions.
Additional information and disclosures: I continue to favor a hedged approach towards long equity positions put in place from time to time tied to Investor Sentiment extremes. The cost of collared option protection (selling out of the money covered calls and buying out of the money puts) is relatively nominal compared to the potential downside market risks. You might also consider spending just 1% per year of your total equity exposure on buying deep out of the money put options. The purpose of Trade Signals is to begin a dialog around a disciplined risk management approach on core equity portfolio exposure.
33/33/34 – My broader view is outlined in a piece called The Portfolio Construction Game Plan for 2013. And subsequent posts at www.cmgwealth.com.
Modern Portfolio Theory is alive and well. The problem is that most portfolios do not include a broad enough set of important risk diversifiers and far too many individual investors chase into and out of the stock and bond market.
60/40 is not diversified in a low yield, low dividend, relatively high PE valuation world, yet those asset categories are important within the construct of a broadly diversified investment portfolio and the risks can be inexpensively hedged from time to time.
To me, a balanced portfolio today is comprised of 33% Equity (hedged from time to time), 33% Fixed Income (tactically managed) and 34% Tactical-Trading-Alternatives. Of course, you may allocate differently based on your risk level, age, needs, time horizon, etc.
Trade Signals was created with the intention of providing a disciplined process to hedge the long-term equity portion of a well diversified portfolio. You will be right from time to time and look like a genius in those moments and, frankly, you will also be wrong from time to time and look less than spectacular. I am far less concerned about getting a short-term directional call correct. I am more concerned about making money. For me, it is about inexpensive risk management in a high risk world. The cost of protection is nominal if executed correctly.
Investor sentiment indicators have helped me over the years and I hope that the statistical math behind investor sentiment extremes (human behavior) can help enhance the risk management of the equity portion of your portfolio(s) as well.
Overview: A disciplined equity hedge – risk management approach
Several times each year investor emotion reaches levels of Excessive Optimism and several times each year emotions reach levels of Extreme Pessimism. A strategy idea I favor is a disciplined risk management equity (hedge) approach as it relates to the long-term equity portion of a portfolio. Initiate hedges when investor sentiment reaches Excessive Optimism and remove hedges at periods of Extreme Pessimism.
A collared option strategy which involves writing covered out of the money calls and at the same time buying out of the money puts is something to consider. It is a relatively inexpensive hedge approach and allows your client to stay on plan with their long-term equity exposure. The game plan is to implement the hedge just a few times each year tied to sentiment extremes. Then remove hedges tied to Extreme Pessimism. Go to www.cboe.com and search for “collared option strategy” to learn more. I favor selling 5% out of the money calls and buying 5% out of the money puts with maturities several months out. It is important to manage to your risk tolerances/investment objectives but at most budget spending a small percentage of your equity exposure each year.
Given the overbought extremely optimistic nature of the market today, I believe spending a small amount of money to protect that long exposure is prudent.
Please note that this is absolutely not a recommendation to buy or sell any security. For discussion purposes only.
A note on active hedging
Within the long-term secular bear environment I believe we are in, I favor hedging the long-term equity portfolio exposure tied to periods of Extreme Optimism and removing those hedges tied to periods of Extreme Pessimism. As you can see in the above charts, there are just a few times each year that the market moves into “Extreme”. I like put options and covered calls against long equity exposure. Never sell “naked” put or call options. Another idea is to budget a percentage of your long equity exposure to actively put on and take off exposure to a leveraged inverse index based ETF.
I believe that we are in a period of time which favors actively hedging long equity exposure. I like putting hedges on when investors are extremely optimistic and removing hedges when investors are extremely pessimistic. The focus on the long equity portion of your portfolio is to enhance return, reduce risk and preserve capital. Go to www.cboe.com to learn more about options. All investments involve risk.
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Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by CMG Capital Management Group, Inc (or any of its related entities-together “CMG”) will be profitable, equal any historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. No portion of the content should be construed as an offer or solicitation for the purchase or sale of any security. References to specific securities, investment programs or funds are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations to purchase or sell such securities.
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