The Nasdaq Composite is showing a positive return for 2020, even though the unemployment rate has hit its highest level since the Great Depression.
These two data points do not seem to belong together. They are a head-scratcher.
Perhaps the forward-looking Nasdaq “sees” a large dose of good news that is not yet visible to the human eye. Or perhaps the Nasdaq, like most Americans, got so sick of sheltering in place that it decided to go outside and run around for a bit.
Whatever the reason, the stock market rally has become a delight to most investors recently. But the good vibes are flowing so fast and furiously that some investors may be wondering, “Is this too much too soon? Should we be having this much fun while the unemployment rate is soaring into the stratosphere, millions of businesses are shut down or operating at a loss, the coronavirus pandemic continues, and some of the most meaningful civil unrest since 1968 occurring across the nation?”
If you find yourself asking these sorts of questions and if the soaring rally in the stock market is unnerving you because you fear that its rapid gains could quickly give way to rapid losses, then you might also be the sort of investor who is thinking about how to hedge against that possibility.
Your Eight-Item Menu for Rally Protection
Generally, portfolio hedges that individual investors can implement fall into one of the following categories:
- Selling stocks to raise cash
- Buying put options
- Selling call options
- Selling short individual stocks or exchange-traded funds (ETFs)
- Buying “inverse” ETFs that bet against a specific stock market index or sector
- Buying gold
- Buying “volatility” ETFs or exchange-traded notes (ETNs) that bet on rising volatility
- Buying long-short ETFs or funds
Each of these hedging tactics can provide some measure of protection during a stock market selloff. That said, hedging a portfolio effectively is not an easy task. Even professional investors struggle to do it well.
Hedge No. 1 – selling stocks to raise cash – is the one and only surefire hedging tactic. Because it replaces stocks with cash, it moves some portion of your portfolio out of harm’s way. That’s why I usually recommend this simple hedge for most investors. If you’re genuinely worried about the prospect of a selloff, sell some of your stock holdings. Period.
But for those folks who wish to remain invested and not raise cash, the other seven hedging tactics can sometimes produce worthwhile results.
For example, the members of my Fry’s Investment Report service recently used Hedge No. 5 – Buying “inverse” ETFs that bet against a specific stock market index or sector. Inverse ETFs rise in price when the underlying securities fall in price, so they perform well during market selloffs.
Our first try with an inverse ETF produced a rapid 43% gain, which we locked down during the March selloff.
Hedge No. 6 – buying gold – is the granddaddy of hedging tactics. Although gold possesses no automatic inverse relationship with the stock market, its price tends to rise when share prices fall … especially if share prices fall a lot.
And we are seeing that exact result in the Fry’s Investment Report portfolio, as my gold-focused recommendations are producing solid gains amid the stock market volatility.
We’ve been talking about gold a lot here recently in Smart Money, but in this issue I’m not going to focus on gold, inverse ETFs, options, or cash, as most investors are already somewhat familiar with these hedging tactics.
Instead, let’s focus on one of the hedges from the list above that are somewhat exotic and probably unfamiliar to most investors…
The Fear Gauges
Hedge No. 7 – buying “volatility” ETFs or ETNs that bet on rising volatility – provides an interesting way to hedge a portfolio because they rise in price whenever the stock market falls.
The mechanism behind these ETFs is a bit complicated, so let me try to simplify it a bit. When investors talk about volatility as something that can be bought or sold, they usually are talking about the CBOE Volatility Index (VIX).
The VIX, also known as the “fear gauge,” tries to put a hard number on the average level of fear among stock market investors. To arrive at this hard number, the VIX tracks the pricing of certain put and call options on the S&P 500 Index.
When the stock market is falling, investor demand for “protection” increases, which causes option prices to rise. The more that people desire a certain product, the higher the price goes. That’s simple supply and demand.
So in this case, when option prices rise, the VIX rises.
Therefore, a high VIX reading indicates a high level of investor fear and a low reading indicates a low level of fear. When these readings reach extreme levels, either high or low, the stock market tends to reverse direction … at least for a while.
Volatility-based ETFs and ETNs enable investors to ride the ups and down of stock market volatility and, hopefully, profit from them.
At least three different ETFs/ETNs track the VIX. All of these securities delivered the goods during the stock market’s steep slide in March. For example, the ProShares VIX Short-Term Futures ETF (NYSEARCA:VIXY) soared nearly 500% in a matter of days.
A gain of that size can come in handy during a stock market selloff. But be forewarned, when the stock market is rising, these securities produce investment results that range from bad to horrible.
Prior to the March selloff, each of the securities in the table had tumbled more than 60% during the preceding 12 months.
That’s what happens when you bet on falling share prices … and they go up instead.
These vehicles are not for the faint of heart. Attempting to profit from them is a little bit like trying to transport cases of eggs on the back of a rodeo bull. The whole thing might turn out fine. But if it doesn’t, you’ve got a big mess on your hands.
So if you’re hoping to profit by using these VIX funds, make sure that your market timing skills are nearly flawless.
Or, you can learn more about what we’re doing at Fry’s Investment Report. We’re putting into play not only gold and inverse ETFs, but also Hedge No. 8 – buying long-short ETFs or funds.
For more on that, go here.
P.S. I’ve found 40-plus 1,000% or higher stock market winners. I beat 650 of the world’s most famous investors (including Bill Ackman and David Einhorn) in a contest. And today I’m revealing my next potential 1,000% winner for free, right here.
Eric Fry is an award-winning stock picker with numerous “10-bagger” calls — in good markets AND bad. How? By finding potent global megatrends… before they take off. And when it comes to bear markets, you’ll want to have his “blueprint” in hand before stocks go south. Eric does not own the aforementioned securities.