Hedging For The Next Market Correction: 5 Winning Investments And 5 Surprising Losers

By | October 27, 2015

Scalper1 News

Summary More market correction indicators are incoming. One method of hedging against a market correction is in choosing ETFs uncorrelated to the market. Here, we look at 10 investments that should be good hedges. Five emerge as winners while five more emerge as losers. (click to enlarge) As I run an “at least weekly” newsletter about hedging against bear markets , market corrections, and market crashes, I am often watching the leading indicators that might imply such an event in the future. My partner at Stock Barometer, Jay DeVincentis, recently sent me an email explaining that he has seen data from the ECRI and infers another correction a la last August, as in the chart above. I have also seen the bearish leading indicators on the rise through my own record. For instance, we’ve recently seen a drop in retail sales, PPI, industrial production, and job openings. I’m not exactly 100% with Jay here because from a seasonal viewpoint, we are approaching a time at which stocks tend to enter a bull market (e.g., November of a pre-election year). As you can see from the chart above, we only recently have recovered from the last correction. Some might say we still haven’t fully recovered. In a way, I wanted to wait to write this article, but the truth is: knowing this earlier is better than later. Overall, we falling economic leading indicators, weak money flow, and higher volatility, the more conservative of us should reconsider the method of hedging used in our portfolio allocation. Though the standard of “diversification” varies across investors, one rather “solid” method of choose stocks to use as hedging vehicles is tracking the correlations of said stocks to the market as a whole. In this article, I’m doing this for you, pointing out the winners as well as some stocks that many would think are winners but are actually not. Now, you just saw me mention “correlation,” which can be interpreted in several ways. In this article, my definition of correlation is – while still a objective statistical number – the variability that market movements can explained for a given stock’s variability. When I refer to a stock “uncorrelated” to the overall market, I’m using correlations of 0 to 0.3. I am purposefully ignoring negatively correlations because the purpose of this article is to inform you of some safe investments during the wait for a bear market , not investments that will fall during a bull market yet rise during a bear market. With the correlation cutoff points I’ve chosen, statistically, general market changes can only account for 10% or less of the variation in the investments I mention below that are “uncorrelated” to the general market. The other investments I mention – those that seem as if they should be uncorrelated to the market but are really not – move in ways explainable by the market to an extent of 10% to 40%. We are looking to build a portfolio – or at least section of a portfolio – that is hedged against a market correction similar to that in the graph above. For this reason, I pored over a large selection of investments, mainly tracking indices and ETFs against the S&P 500 during the period of the last market correction, using August 18 as the starting date because that was when the volume shows the beginning of the selling. What follows are winners and close-calls. Note that some of the following will seem like common sense. However, you are likely to find a few surprises. Unless otherwise mentioned, true prices or direct indexes were used to calculate correlations (e.g., the correlation with gold was calculated with historic gold prices and the correlation with treasury bonds was calculated with the ^TYX index, whereas that with municipal bond prices was calculated with the MUNI ETF and recalculated with other municipal bond ETFs to ensure the correlation). Read on: Winners Gold. Gold is falling, yes, and it might be coming back, yes… but that’s not the point here. Gold overall was uncorrelated to the market during the last market correction. Gold is still a good hedge today, even if you’re not sure where it’s headed. Invest in: the SPDR Gold Trust ETF (NYSEARCA: GLD ) or the iShares Gold Trust ETF (NYSEARCA: IAU ). Municipal Bonds: Municipal bonds often come with the benefit of allowing you to hedge against inflation (and market corrections, of course) without having to deal with federal income tax. Local governments (e.g., states) issue these bonds to fund long-term projects such as the construction of hospitals and roads. The interest rates and open interest in these instruments are unlikely to change during a market correction, and ETFs of municipal bonds seem to hold their value quite well during a bear market. This correlation was calculated using MUNI as a proxy. Invest in: the PIMCO Intermediate Municipal Bond Strategy (NYSEARCA: MUNI ) or the Market Vectors High-Yield Municipal Index ETF (NYSEARCA: HYD ) Mexican Airports: Yes, it’s weird that I’d mention this as a general area fit for hedging against a market correction, but I came across a specific stock perhaps mislabeled as an ETF. I looked into it in the same way and found it to be uncorrelated to the market during the most recent correction. The name of the stock is Grupo Aeroportuario del Pacifico (NYSE: PAC ). In a sense, it really is an ETF on Mexican airports because this company essentially owns a monopoly on airport management and development throughout Mexico. While it has a market cap of nearly $6 billion, fewer than 600 Seeking Alpha readers hold it in their portfolios. This correlation was calculated with PAC directly. Invest in: Grupo Aeroportuario del Pacifico Treasury Bonds: You can buy a treasury bond with denominations starting at $1,000. This makes them available to virtually every type of investor. Every six months, you gain a fixed interest rate. The maturity of a treasury bond tends to be long: sitting at 30 years. These long-term investments are uncorrelated with the market and stayed strong during the recent market crash. You can also gain exposure to these bonds through ETFs, such as the one I mention below. Invest in: the iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ). Biotechnology: Strange right? Biotech stocks tend to trade on NASDAQ, which is even more volatile than the NYSE. We typically think of biotech stocks being great growth stocks during a strong economy and underperformers when the economy is hurting. But the success of the biotech industry relies more on innovation than the economy, it would appear, as per the low correlations I found. That is to say, perhaps investors realize that drugs will always be needed, even when people are afraid of spending money during a recession. The market correction didn’t seem to hurt the biotech industry much. The following ETF tracks this industry and showed to be uncorrelated with the general market during the recent correction. This correlation was calculated with IBB as a proxy. Invest in: the iShares NASDAQ Biotechnology ETF (NASDAQ: IBB ) Close Calls Here are the investments that you’d think would perform much like the investments above. I am probably not the only one surprised to find that these following investments followed the market to considerable extent during the last correction. Intermediate-Term and Short-Term Bonds: You would think that most bonds move in a similar fashion during a market correction, despite the maturity of the bond. Well, you’d be wrong. I found investment-grade bonds with shorter maturities falling during the last market correction. These bonds won’t keep you safe if we see a repeat of the August fiasco. These correlations were calculated with the ETFs as proxies. Avoid: The PIMCO Total Return ETF (NYSEARCA: BOND ) and the iShares 10+ Year Credit Bond ETF (NYSEARCA: CLY ) Base Metals: Unlike gold, base metals such as aluminum, copper, and zinc were correlated with the recent market dip. If you’re looking to invest in metals but want to avoid the falling gold and silver markets, you’re barking up the wrong tree with base metals. Avoid these. Avoid: The PowerShares DB Base Metals ETF (NYSEARCA: DBB ) Crude Oil: Yes, oil seems to be doing its own thing these days. Oil is a complex beast affected by international events and seems to have hit a bottom. But still, oil was correlated with last quarter’s market slump. So if we hit another correction and you’re thinking of “buying oil at a low,” think again. At least wait until the economy is looking up to dip your hands into oil. Avoid: The United States 12 Month Oil ETF, LP (NYSEARCA: USL ) Emerging Markets Debt: Another bond category that betrays common sense is that of emerging market debt. Though at this point in history, all stock markets are correlated to an extent, you would think foreign bonds wouldn’t have fallen the dive the US stock market took. But you’d be wrong. Bonds from emerging markets fell as well. Some investors use emerging market bonds – which tend to be more risky than US bonds for obvious reasons – as low-risk investments because they believe that bonds issued by foreign countries are uncorrelated to the US market. The recent correction shows this strategy to be incorrect. This correlation was calculated with PCY as a proxy. Avoid: The PowerShares Emerging Markets Sovereign Debt Portfolio ETF (NYSEARCA: PCY ) Corporate Bonds: Bonds issued by corporations are often looked upon as safe, especially those that are of investment grade. For hedging while still retaining aggressive growth, many investors choose these bonds over government-issued bonds because of the higher yield rate. The common believe in the investment community is that junk-grade corporate bonds correlate with the market and shouldn’t be used for hedging but that long-term investment-grade corporate bonds are perfectly fine for hedging. I found this to be false, with corporate bonds falling during the recent correction. This correlation was calculated with VCLT as a proxy. Avoid: The Vanguard Long-Term Corporate Bond Index ETF (NASDAQ: VCLT ) Example Portfolios and Their Performances So what would happen if we took these two lists and made from them two portfolios? Let’s take a look at what would have happened during the recent market correction for portfolios of the “winners” and “close calls.” And then let’s see what would happen if you built these portfolios at the beginning of the year, holding all the way to today. The Winners This portfolio consists of all the ETFs I recommended in the “Winners” section above. Again, this list is: Here is what happened during the market correction: (click to enlarge) That is, your portfolio would have trended sideways while the market itself fell 10%. And here is where you’d be if you built this portfolio at the beginning of the year: (click to enlarge) Your portfolio would have climbed 6%, while an index fund would be still recovering. The Close Calls This portfolio consists of all the ETFs we’d expect to do well in a bear market yet showed a correlation with the market during the time of the correction beginning in mid-August. This portfolio consists of all the ETFs in the “Close Calls” section above. Here is our portfolio: Here is what happened during the market correction: (click to enlarge) The close calls started dropping even before the bear market and then moved in tandem – but under – the market during the correction. And here is where you’d be if you built this portfolio at the beginning of the year: (click to enlarge) You’d still be below the market, unfortunately. I Want Your Input Obviously, I simply don’t have the time to cover every industry. While reading this article, you probably thought of at least one investment that should have gone in my “Winners” section. Let me know about it in the comments section below. Request a Statistical Study If you would like for me to run a statistical study on a specific aspect of a specific stock, commodity, or market, just request so in the comments section below. Alternatively, send me a message or email. Scalper1 News

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