This Trade Works Like Clockwork

The past few weeks we’ve been enjoying the sights and sounds of Colombia with a group of friends, a country which has gradually been dragging itself out of a nightmarish civil war, constantly overshadowed and closely tied to drug cartel wars which pepper it’s history. Much of that seems a distant memory now and the rise of a middle class, the flip side of which is a fairly rapidly falling unemployment numbers and poverty levels, is evident all around. Colombia has benefited in the last decade from strong commodity prices and on the face of it is doing well.

In the short term I think there comes some serious dislocations in the market for a host of reasons which we discussed in earnest late into the nights. I like a bit of chaos as prices typically move accordingly and in emerging markets like Colombia they tend to move more violently than elsewhere. This is due to relative illiquidity amongst other things.

I’ll have more on this next week but due to what the broader markets, especially those in the US, are delivering us right now I felt it better to provide some thoughts from our colleague Mark Schumacher.

This past week the Dow Jones industrial average fell almost 900 points or 5.1% from 17,352 to 16,460. The index is now 10.1% below its 18,312 peak reached on 5/19/15 crossing the 10% mark which defines a technical correction.  For all of 2015 it is down 7.7% while our portfolios are still up this year. I’ll provide a thorough summary at the end of Q3.

The catalyst for the recent correction is renewed global growth fears which are centered on concerns about China having a hard landing as it attempts to become less dependent on exports by growing its service economy. The market is interpreting (correctly in my opinion) the recent nearly 2% devaluation of the yuan as evidence that China’s problems are worse than previously thought… why else would they need to make such a move on top of all the financial stimulus they have been pumping into their system. If trouble is indeed brewing in the 2nd largest economy and #1 exporter ($2.25T vs. 1.61T for the US), than there will be ripple effects across the globe.

There is no guarantee that US stocks prices will suffer a great deal especially for domestically oriented companies, plus some US businesses will benefit from a weaker China. However in case trouble spreads or the negative momentum simply feeds on itself for a while I purchased portfolio insurance in the form of three ETFs that will appreciate during a US stock market sell off.

Insurance: How Much and Which Products

I did not purchase enough insurance to cover our entire portfolio of investments as that would be overkill and too expensive. The products we own cover 26% – 30% of our entire portfolio including assets with limited risk. I am considering increasing it to cover up to 35% depending on how events develop but currently don’t see a need to go higher than that.  Should another step be necessary for greater safety, I would simply sell some shares and hold the cash for a while, but I much prefer sitting tight as our holdings offer very good value especially at today’s prices. I expect the businesses we own to flourish for years because they are either leaders in their respective fields while benefiting from strong trends, or they are super cheap turnaround candidates that we are generating income from. We are best served by sitting tight with these investments while having some insurance rather than exiting now then trying to time when to get back in again.

Gold may appreciate during a stock market sell off but it does not always work that way, therefore I do not think of gold as portfolio insurance.

The three ETFs we purchased were:

1. SDS – moves inversely 2-1 vs. the S&P 500 index which is a basket of 500 very large US stocks spanning many industries.
2. QID – moves inversely 2-1 vs. the NASDAQ 100 which is a basket of large US technology stocks. This nicely correlates with some of our technology holdings.
3. BIS – moves inversely 2-1 vs. the NASDAQ biotechnology and pharmaceutical index which has had a crazy run up.

FYI, because these are -2x products we can cover 30% of our portfolio by investing just 15% of our assets in these ETFs. These inverse products experience some daily rebalancing decay so they are not buy and hold investments. You don’t sit on them for years. Several months is more typical, and I only plan to hold them for as long as the current market weakness continues.

Historical Chart: Corrections and Recoveries

The two biggest things I take away from observing the 20-year stock market chart below (which is on a log scale) are:

  • Corrections happen quickly while recoveries happen more gradually but last longer. This is where the saying “stock investors ride escalators up but take the elevator down” comes from. The majority of the time you will be on the escalator. Right now we are in the elevator.
  • The stock market rarely moves sideways. It is nearly always either trending up or trending down. I believe this is purely due to investor psychology rather than fundamentals such as GDP and business profits which fairly often trend sideways. Best not to ignore investor psychology at least over the near term as it drives stock price trends, in my opinion.

I would say this historical chart puts the size of the recent decline from 2,100 to 1,970 for the S&P 500 index into proper perspective which is why it is not too late to buy some portfolio insurance.

20-Year Chart: US Stock Market (SPX)

The 15-year chart below is simply to demonstrate the crazy run up biotech stocks have had over just the past few years making that sector vulnerable to a price correction as many of these stocks sport multi-billion dollar valuations but don’t yet have any products on the market.

15-Year Chart: US Biotech & Pharma Stocks (IBB)

Bottom Line

The stock market correction that I have been worried about for a few years is finally here. I hope it will be shallow and short lived but hope is not a defensive technique so I thought it prudent to buy some protection in case the selling continues. Having a portion of our portfolios appreciate during a sell off is even better than holding extra cash.

Furthermore, I have a plan should volatility spike really high; I will execute our time-tested strategy of buying ZIV or XIV which I will reiterate should we put that plan into action.
Members have just received an alert on this very trade.

Until next week…

– Chris

“A man who does not plan long ahead will find trouble at his door.” – Confucius


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