By Alex Daley
Let’s be blunt: stocks are looking expensive right now.
Sure, maybe on a relative valuation to estimated forward earnings, things aren’t that expensive. Or using a historical index of price to sales and tangible book value across the S&P 500, it doesn’t look awful. But the simple fact is, the S&P and Dow are both up more than 50% in two years’ time, and many specific sectors like gold miners or junior explorers are up even more.
Many investors who took advantage of the big discounts the 2008 panic provided are stuck between a rock and a hard place: sitting on large gains and not wanting to miss out on any further growth, yet worrying about a systemic hiccup that could wipe out large portions of their portfolio, just like last time.
While market bullishness is now at an all-time high, according to surveys by Investors Intelligence and the American Association of Individual Investors, investors seem at least anecdotally nervous about their own portfolios. More and more often these days, I hear the question, "Should I be getting out of this market?"
My answer inevitably perplexes most who ask, when I respond with the simple question, "Well, do you have insurance?" If you were worried about your home getting wiped out in a flood or fire, you’d probably purchase insurance on it. Same with your car, your boat, even the key employees at your business. With most assets in life, we take the pragmatic approach and keep them insured against catastrophic loss. There’s a cost, sure. But one we usually happily pay to have peace of mind.
But if the crash of 2008 showed us anything, it’s that most investors, even the so-called professionals, are woefully unprotected against the risks of a big market crash. They simply ignore the volatility of the markets and trudge forward with the idea that "in the long run, stocks only go up." For many of us, our equity portfolios are the largest single asset we have by a long shot, and yet the majority of investors sit completely exposed.
Of course, you cannot go to an Allstate agent and purchase portfolio insurance. Instead, your options are limited mostly to the hedges available on the financial markets (or some more exotic choices if your means are sufficient, but that is beyond the scope of this article).
If you, like many investors, keep the majority of your holdings in relatively liquid stocks on the U.S. exchanges, one of the first places to look is options. Say you are one of the investors who has been along for the ride on Netflix, and your position is up 700% in five years, with the stock trading at about $230/share. Maybe you are willing to live with a 10% haircut, but no more. In that case, you could purchase puts to cover your holdings on the stock out to September, with a strike price of $205. The current premium on such puts is about $20, or less than 10% of the share price.
That might sound like a lot to pay for insurance. But the nice thing about options is, you can always let someone else pay for your policy. Calls for Netflix at $250 with the same expiration are also trading right around $20. Sell an equal number of covered calls, and your insurance is basically free. If the stock rises, you’ll still get the strike price, sharing in some of the gains (albeit now capped). And if it crashes, you’ll be able to dump your shares onto someone else at the prearranged price.
Options are a great tool for insuring a portfolio of widely traded stocks, but for some investors, the stocks that make up large portions of their portfolios include thinly traded companies, or non-U.S. equities, with little or no options volume to support direct hedges. In the case of these types of investments, you have basically two options: find an inversely correlated asset or instrument (your asset goes down, this one goes up), or buy insurance against the market as a whole.
The former is often a difficult thing to find, as in extreme conditions all things tend to correlate (another lesson of 2008). If you can find it, snap it up. Interest rate hedges for bonds, for instance. Or even gold to the U.S. dollar. The latter, however, is much more easily found these days. Funds and options exist to play the long and short side of almost every major index or asset class. One of the favorites of pros, though, is the VIX, an index that tracks the volatility of the S&P 500. The wilder the market, up or down or all around, the higher the VIX index goes.
The index is currently near a two-year low as the market has had slumping volume and relatively little drama lately. If things take a major swing in the near future, having some options on the VIX could offset a good percentage of losses elsewhere in your portfolio. There are a lot of vehicles from direct options to ETFs and ETNs with differing time horizons and leverage levels.
The insurance principal doesn’t just extend to equities either. Investors with large gold or silver holdings, following these historic run-ups in the commodities’ prices, might consider grabbing some options in the futures markets, like buying puts on silver in the 30s now that it is trading at historic highs. These can be had cheaply and provide huge peace of mind toward protecting some of the newly accumulated wealth.
None of this is as simple as buying car insurance. But it’s possible for almost any portfolio, and given the current market, it’s probably a smart move. Any good financial advisor should be able to help you figure out a strong mix of insurance options for your specific portfolio. And you can turn to the pages of The Casey Report for some market level recommendations that will help you survive and thrive during the next leg down. 15 minutes could save you 15% during the next market downturn.
[Here’s another form of portfolio insurance: foreseeing where the current events lead us and being well prepared when most investors are asleep at the wheel. The Casey Report team – our in-house guru Doug Casey, economists Bud Conrad and Terry Coxon, and investment pro David Galland - provide in-depth trend analysis, economic and market research, and the instinct of bloodhounds to help subscribers make the trend their friend. Read more here.]