S&P 500 Index 1563
By Steve Blumenthal
March 27, 2013
Sentiment Charts, PE Chart and Near Record Margin Debt
Investor Sentiment remains at Extreme Optimism in the Crowd Sentiment Poll and has moved to Neutral in the NDR Daily Trading Sentiment Composite. Having moved to a “RISK OFF” hedged position when the S&P 500 Index reached 1500, the S&P has advanced about 4% to 1563 and is challenging its all-time high. That is good news for the equity portion of your portfolio.
Risk remains nonetheless and sentiment remains elevated. The idea is to use sentiment extremes as a timing signal to put on and take off risk protection. No indicator is perfect, though the math behind sentiment extremes is hard to ignore. The cost of the hedge is inexpensive and leaves you in a position to profit should the market continue higher as has been the case most recently.
I continue to favor a collared option (hedge) against equity portfolio exposure today. This disciplined risk management approach enables you to capture the gain, less a small expense to write out of the money covered calls and buy out of the money puts (collared option hedge strategy). Think of it as portfolio insurance that is put into place and removed just a few times each year.
For those who do not believe there is significant event risk, a disciplined hedged approach may not be worth the insurance expense. Following are the sentiment charts as well as a concerning chart on the high level of current NYSE Margin Debt and the most recent PE chart reflecting fair value, upside market potential and downside market potential.
Investment Sentiment charts 3-27-2013:
Chart 1. NDR Daily Trading Sentiment Composite. Neutral – REMAIN RISK OFF (hedge).
Chart 2. NDR Crowd Sentiment Poll – Extreme Optimism (Bearish)– REMAIN RISK OFF (hedge).
NDR Medium Price Earnings Ratio with Historic Median – PE 18.5
Note that the historic median PE (49 years) is 16.6. At a PE of 18.5 at the end of February, the medium fair value (reported earnings x 16.6) of the S&P 500 Index was 1357. This suggests that the market is currently 13% overvalued (using 1563).
Also note overvalued would be a +1 standard deviation move above the median to 1783 and undervalued would be a -1 standard deviation move below the median to 932. This is a reasonable way to look at the attractiveness of equity values. It is best to buy when what you are buying is inexpensive vs. expensive.
Margin Debt in NYSE Accounts
An additional note of caution comes courtesy of this chart from KimbleChartingSolutions.com/blog. Note the pink lines in the chart marking prior peaks in Margin Debt and the corresponding peaks in the S&P 500. Cause for concern…
With warm regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
steve@cmgwealth.com
610-989-9090 Phone
610-989-9092 Fax
I continue to favor a hedged approach towards long equity positions. 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. I am looking for Extreme Pessimism Sentiment readings tied to logical technical support (1440-1460 first support area) as a point to remove the option hedge.
33/33/34 – My broader view is outlined in a piece called The Portfolio Construction Game Plan for 2013.
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.
The forward projected 60/40 expected return of just 4.37% is the lowest expected return in the last 14 decades. Source: Expected Returns – Research Affiliates. Here is a link to the Expected Return charts on our website.
The good news is that there remain ways to drive returns. I believe portfolios can be constructed in such a way as to drive return whether one is correct or incorrect in his forward view. I favor a broader allocation of 33/33/34 that includes an allocation to tactical and other liquid alternative investments. Endowments have managed towards broader diversification for years and I believe the approach better captures the core principals of Modern Portfolio Theory (MPT).
MPT is “a mathematical formulation of the concept of diversification in investing with the aim of seeking a diversification of investment assets that has collectively lower risk than any individual asset”. 60/40 falls exceedingly short of meeting this definition.
Given the global macro risks that exist today, as well as the relatively high valuations, low dividend yields and low interest rates, some form of proactive risk management makes sense to me. One day soon (maybe within the next five years), PEs will be much lower, dividend yields will be much higher and interest rates will be much higher.
Opportunity will present itself in a period of crisis and while others are panicking out, you’ll be in a position to capitalize. Until then, I favor a broader portfolio construction approach (33/33/34) that includes a disciplined hedging strategy to protect the long-term focused equity portion of your portfolio(s).
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. 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.
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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