S&P 500 Index 1496
By Steve Blumenthal
February 27, 2013
RISK OFF
Hedge Long Equity Exposure and/or Defensively Raise Cash. Excessive Investor Optimism Extremes remain though Daily Trading Sentiment is beginning to improve.
Investment Sentiment charts 2-27-2013:
Chart 1. NDR Daily Trading Sentiment Composite. Neutral – REMAIN RISK OFF (hedge).
Daily Trading Sentiment has moved into the Neutral Zone. I am looking for Sentiment to move into the Extreme Pessimism Zone to remove hedges and switch to Risk On.
Chart 2. NDR Crowd Sentiment Poll – Extreme Optimism – RISK OFF (hedge).
The weekly crowd sentiment remains in the Extreme Optimism (Bearish) zone. I am looking for the overbought, bullish nature of the market to correct itself. The trigger will be a move into the Extreme Pessimism zone. Continue to hold hedges in place.
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. Today is one such extreme. 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.
My broader view is outlined in a piece called The Portfolio Construction Game Plan for 2013.
Please note: Within your portfolio construction process, I do not recommend hedges against your tactical strategy allocations as they already offer a diversifying return stream to your overall portfolio. There is no need as these strategies should be considered within the framework of your total portfolio for its return and non-correlating risk benefits. If a manager has a process with edge and a proven history to execute his trading process, then ask yourself if the strategy can make money in both up and down trending markets and monitor accordingly. Make sure the manager is sticking to his process. I believe that transparency and liquidity are mandatory. Of course, past performance cannot predict or guarantee future performance.
33/33/34
Modern Portfolio Theory is alive and well. The problem is that most portfolios do not include a broad enough set of important risk diversifiers. 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.
I continue to favor a broadly diversified portfolio that includes allocations to three asset categories not two. I believe 60/40 will underperform with historical evidence projecting a 4.37% forward 10-year expected return (the lowest in 14 decades). Source: Expected Returns – Research Affiliates.
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.
Importantly, there are a number of ways to risk protect long equity and fixed income exposure and there are a number of outstanding liquid tactical risk diversifying solutions for you to consider. The goal is to enhance overall portfolio return and reduce risk.
Please feel free to forward this to a friend or have them go to http://www.cmgwealth.com/ and subscribe to our free letter at the bottom of the home page.
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 management of the long equity portion of your portfolio(s) as well.
With warm regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia
steve@cmgwealth.com
610-989-9090 Phone
610-989-9092 Fax
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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