RIA PRO: Too Fast, Too Furious – Hedging For A Short-Term Correction

By Lance Roberts | November 16, 2019

, RIA PRO: Too Fast, Too Furious – Hedging For A Short-Term Correction

  • The “QE, Not QE” Rally Is ON
  • Too Fast, Too Furious
  • Why We Are Hedging
  • New: Financial Planning Corner
  • Sector & Market Analysis
  • 401k Plan Manager

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, RIA PRO: Too Fast, Too Furious – Hedging For A Short-Term Correction

The “QE, Not QE” Rally Is On

Last week, we discussed the “QE, Not QE” rally:

“Just recently, we released a study for our RIAPro Subscribers (30-Day Free Trial) on historical QE programs and what sectors,  markets, and commodities perform best. (If you subscribe for a 30-day Free Trial you can read the entire report ‘An Investor’s Guide To QE-4.’)”

‘On October 9, 2019, the Federal Reserve announced a resumption of quantitative easing (QE). Fed Chairman Jerome Powell went to great lengths to make sure he characterized the new operation as something different than QE. Like QE 1, 2, and 3, this new action involves a series of large asset purchases of Treasury securities conducted by the Fed. The action is designed to pump liquidity and reserves into the banking system.

Regardless of the nomenclature, what matters to investors is whether this new action will have an effect on asset prices similar to prior rounds of QE. For the remainder of this article, we refer to the latest action as QE 4.’

The following is one of the tables from the article.

, RIA PRO: Too Fast, Too Furious – Hedging For A Short-Term Correction

As you will notice, all major markets increased in value during QE-1, 2, and 3.

, RIA PRO: Too Fast, Too Furious – Hedging For A Short-Term Correction

Regardless, whether you believe the Fed’s actions are “QE,” “QE-Lite,” of “Not QE at all” is largely irrelevant.

What is relevant is that each time the Fed has engaged in monetary programs, the markets have risen. Therefore, it should not be surprising investors now have a “Pavlovian” response to the Fed’s “ringing of the bell.” 

During the past few weeks, we have discussed the probability of a year-end rally, which would be supported by both the Fed, and a “trade deal.”  The following links will catch you up on our premise.

With the Fed cutting rates, Trump touting “trade deals,” and now “tax cuts for the middle class,” not to mention the Federal Reserve increasing their balance sheet, it should not surprising markets have rallied over the last 5-weeks as shown below.

, RIA PRO: Too Fast, Too Furious – Hedging For A Short-Term Correction

Think about it this way, in just 5-weeks the market has almost advanced as much as the long-term historical average annual return.

This should suggest two things.

  1. The market has already priced in a bulk of the benefit from the additional liquidity; and, 
  2. The market has advanced too quickly.

, RIA PRO: Too Fast, Too Furious – Hedging For A Short-Term Correction

Too Fast, Too Furious

On Tuesday, I posted a series of charts which showed the rather rapid reversion from more extreme bearishness mid-summer to more extreme bullishness now.

As I noted:

“But it isn’t just the more extreme advance of the market over the past 5-weeks which has us a bit concerned in the short-term, but a series of other indications which typically suggest short- to intermediate-terms corrections in the market.

Historically, when all of the indicators are suggesting the market has likely encompassed the majority of its price advance, a correction to reverse those conditions is often not far away. Regardless of the timing of that correction, it is unlikely there is much upside remaining in the current advance, and taking on additional equity exposure at these levels will likely yield a poor result.”

What is quite amazing is that this reversal from “bearish” to “bullish” occurred precisely as the Fed began pumping liquidity into the markets. The last time investor sentiment was this bullish was at the beginning of 2018, which eventually led to a near 20% correction.

, RIA PRO: Too Fast, Too Furious – Hedging For A Short-Term Correction

As with above, retail investors are “all in” once again with the smart/dumb money indicator noting an extreme bullish bias of retail investors.

, RIA PRO: Too Fast, Too Furious – Hedging For A Short-Term Correction

Of course, this coincides with extremely low individual cash levels of individuals.

“With cash levels at the lowest level since 1997, and equity allocations near the highest levels since 1999 and 2007, it suggests investors are now functionally ‘all in.’” 

, RIA PRO: Too Fast, Too Furious – Hedging For A Short-Term Correction

With net exposure to equity risk by individuals at historically high levels, it suggests two things:

  1. There is little buying left from individuals to push markets marginally higher, and;
  2. The stock/cash ratio, shown below, is at levels normally coincident with more important market peaks.

Lastly, for a “bullish sentiment” perspective, investment newsletters are now exceedingly bullish.

These are all “contrarian” indicators, which suggest that if everyone is “all in,” there is currently no one left to “buy.” Such conditions typically are associated with short-term market corrections.

However, even if we set aside investor sentiment and positioning for a moment, the rapid reversion is price has sent our technical composite overbought/oversold gauge back towards more extreme levels of overbought conditions. (Get this chart every week at RIAPRO.NET)

, RIA PRO: Too Fast, Too Furious – Hedging For A Short-Term Correction

As noted previously, virtually every measure of volatility has been suppressed as the “fear of a correction” has evaporated.

Low volatility measures are a representation of more extreme levels of investor complacency. Such complacency provides “fuel” for a reversion as investors sentiment transitions from complacency to fear.

As we noted just recently for our RIAPRO.NET subscribers, the divergence of breadth is also indicative of short-term tops in markets.

What all of this data suggests is that markets have risen “too fast, too furious” which raises the probability of a price correction in the short-term.

This is why we have hedged our portfolios last week.

Does that mean we are bearish and betting on the market to crash.

Not at all.

Why We Hedge

Currently, our portfolios are long-biased meaning we have more equity-risk in our allocation than fixed income and cash.

Given the market’s advance, and the data points set out above, and this past Tuesday, we have three choices in how we manage our client portfolios at this juncture:

  1. Do Nothing – if the markets correct, we lose some of our gains and just have to wait for the portfolio to recover.
  2. Take Profits – as we have done with extremely overvalued assets in the past, we can take profits, raise cash, and reduce our equity exposure in advance of a correction. Such actions mitigate the damage of the decline, but positions have to be repurchased, or new ones added, to resize the portfolio in the future.
  3. Hedge – adding a position to the portfolio that is the “inverse” of the market. (the position goes up in value as the market declines.) This action allows us to keep our existing positions intact, and by “shorting against the portfolio” allows us to effectively reduce our equity risk (and related capital destruction) during a market correction.

Why did we choose “Option 3” at this juncture?

Option 1 – is never really a good option. Riding the market up and down, and spending time “getting back to even,” doesn’t make a whole lot of sense.

Option 2 – is something that we took advantage of twice this year already. We took profits at the peak of the market in May and July before both of the subsequent swoons. We also added new exposures in early October. So, taking profits again in some positions would lead to a gross underweight in certain areas of the portfolio allocation.

This makes Option 3 the most optimal at this stage of the rally.

With the Fed engaged in pumping liquidity into the markets, and any day may also include a random market manipulation from a “Trump tweet,” the most opportunistic method to hedge risk is to add a “short S&P 500” index position to the portfolio. The chart below shows the range of options which we expect could occur.

, RIA PRO: Too Fast, Too Furious – Hedging For A Short-Term Correction

  1. Market breaks ABOVE the current upward trending range. We are currently carrying a stop at 3150 for our short position, where we will close it out. Yes, we will have a minimal loss in the position but the rest of our equity holdings will advance more than making up for the differential. (Example: On Friday, the S&P 500 increased .77%, our 60/40 Equity Portfolio with the Short Position rose by .46%)
  2. Market corrects to the currently rising 50-dma and in that process reverses the current overbought condition of the market (top panel, red box) back to oversold. Note: the 50-dma also currently coincides with the previous resistance of this year’s market highs. A retest of this level that holds, and removes the overbought condition as noted, would be very bullish. We will close out the hedge and increase our long-exposure.
  3. If the market breaks below the 50-dma, and is NOT oversold, the next level of support is the lower rising trendline. This is also important support, and a successful test that reverses the overbought condition would require a removal of hedges. 
  4. The last support is the rising 200-dma. If the market test and holds the 200-dma, is oversold, and sentiment has returned to a more bearish position, we will close out our hedges.
  5. IF the market breaks below the 200-dma, we will likely be discussing the process of reducing long positions and increasing short-hedges. 

Importantly, the range of corrections discussed only runs 3-6%, which is well within the normal confines of a bullish correction.

When we discuss hedging against risk, it is invariably taken that we have sold everything and are now betting on a market “crash.” 

Such is hardly the case. We are simply taking prudent actions in the portfolio management process to reduce capital risk, and potentially add some incremental “alpha” to portfolios if a correction occurs.

This is just how we manage risk.

You have a choice to either manage risk, or ignore it.

The only problem is that ignoring risk has a long history of not working out very well.

If you need help or have questions, we are always glad to help. Just email me.

See you next week.

“NEW” – Financial Planning Corner

by Danny Ratliff, CFP

Welcome to the planning corner.

I’m Danny Ratliff a Certified Financial Planner with RIA Advisors.

Starting next week, we will provide an unadulterated look at financial planning norms and myths. We will inform you on financial planning trends, changes in laws and regulations.  The intent is to be a resource of sound financial advice that you, or someone you know, can put to practical use.

We will be covering such topics as:

  • Social Security – take it now or later.
  • Long Term Care – do you really need it?
  • Medicare – the best strategies to maximize your benefits.
  • Workplace Benefits – are you getting the most from them? You may be missing out on “free money.” 
  • Risk Management – what you need to know to mitigate the things that can hurt you. 
  • Estate Planning – now that you’ve got money, tips on how to pay less taxes and not lose it. 
  • Savings Rates – what is important, and what’s not.
  • Accumulation and distribution of assets – taxes, legal issues, and considerations you probably haven’t thought of.

Don’t hesitate to send me an email if you have any questions or topics you’d like us to cover.  We encourage your feedback and look forward to hearing from you.

Market & Sector Analysis

Data Analysis Of The Market & Sectors For Traders

S&P 500 Tear Sheet

, RIA PRO: Too Fast, Too Furious – Hedging For A Short-Term Correction

Performance Analysis

, RIA PRO: Too Fast, Too Furious – Hedging For A Short-Term Correction

Technical Composite

, RIA PRO: Too Fast, Too Furious – Hedging For A Short-Term Correction

ETF Model Relative Performance Analysis

, RIA PRO: Too Fast, Too Furious – Hedging For A Short-Term Correction

Sector & Market Analysis:

Be sure and catch our updates on Major Markets (Monday) and Major Sectors (Tuesday) with updated buy/stop/sell levels


, RIA PRO: Too Fast, Too Furious – Hedging For A Short-Term Correction

Improving – Energy (XLE), Healthcare (XLV)

The relative performance improvement of Healthcare relative to the S&P 500 picked up on Friday as economic data continues to point to weaker economic growth (below 1%). Energy has improved as the rotation to “value” continues but faltered at resistance which is the 200-dma. Energy needs to break above the downtrend to become an attractive candidate for portfolios.

Current Positions: Target weight XLV

Outperforming – Technology (XLK), Materials (XLB), Industrials (XLI), Financials (XLF)

Financials have been running hard on Fed rate cuts and more QE, but rate cuts are, longer-term, not great for net-interest income margins on banks. Combined with the high level of corporate debt on their books, we remain cautious on the sector. But, with the breakout to new highs, we are looking for some consolidation to add exposure to the sector, which is extremely overbought currently.

Industrials and Materials, which perform better when the Fed is active with QE, also broke out to new highs, Given they are extremely overbought, we will look to add back to our position but need a bit of a correction or consolidation first.

Technology has been the clear leader as of late, and the sector made a sharp recovery from weakening to leading relative to the overall market. Like everything else, XLK is extremely overbought so wait for a correction to add exposure.

Current Positions:  1/2 weight XLI, XLB, Full weight XLK

Weakening – Real Estate (XLRE), Staples (XLP), Utilities (XLU)

After having taken profits in our defensive sectors, the rotation from defense to offense has picked up a bit of a bounce on Friday. Utilities, Real Estates broke their 50-dmas and are FINALLY working off the extreme overbought condition that existed. This is good news is they are now very oversold and are a decent entry point for a trade. We are at full weightings currently, but a trade setup is available with a stop at recent lows.

Current Position: Target weight XLRE, XLU, XLP

Lagging – Discretionary (XLY), Communications (XLC)

Discretionary stocks have been a surprising laggard given we are moving in the retail shopping season. I suspect this has more to deal with the “real economy,” rather than just a sector lagging the market currently. Watch XLY, a failure at support will likely suggest a larger corrective process. Communications broke out to new highs on Friday, but is still lagging the overall market. Given the sector is very overbought, be patient for a better entry point.

Current Position: Target weight XLC, XLY

Market By Market

, RIA PRO: Too Fast, Too Furious – Hedging For A Short-Term Correction

Small-Cap (SLY) and Mid Cap (MDY) – Small- and Mid-caps finally broke out of the previous ranges but this past weak slipped back to retest those breakouts. It is crucially important both these markets hold the breakout. The test will come with a correction of the broader market. However, both markets are EXTREMELY overbought currently. Be patient for the right entry point.

Current Position: No position

Emerging, International (EEM) & Total International Markets (EFA)

The same advice goes for Emerging and International Markets, which we have been out of portfolios for several weeks due to lack of performance. These markets rallied recently on news of “more QE,” and finally broke above important resistance. However, these markets are sensitive to the US Dollar which is showing some strength. With both markets EXTREMELY overbought currently, be patient for the right entry point.

Current Position: No Position

Dividends (VYM), Market (IVV), and Equal Weight (RSP) – These positions are our long-term “core” positions for the portfolio given that over the long-term markets do rise with economic growth and inflation. Currently, the short-term bullish trend is positive, and our core positions are providing the “base” around which we overweight/underweight our allocations based on our outlook.

Be aware that all of our core positions are EXTREMELY overbought. A short-term correction or consolidation is likely before a further advance can be made.

Current Position: RSP, VYM, IVV

Gold (GLD) – With QE-4 in play, the most defensive of sectors got hit recently. Gold broke support at the $140 level but held support at $136. Stops should be placed on all positions at $132. Gold is very oversold so a tradeable opportunity is approaching.

Current Position: GDX (Gold Miners), IAU (Gold)

Bonds (TLT) – 

As stated last week, Bonds were extremely oversold from the recent rise in rates. As we stated, that rise in yields was expected, which is why we added a “steepener trade” to our portfolios. Given that we improved our credit quality and shortened duration previously, we are holding our positions for now. We have tightened up our stops.

This past week, bonds held support and bounced late in the week. With yields very oversold more of a rally is likely especially if we see a short-term correction in stocks as we currently expect.

Stay long current positions for now, and look for an opportunity to add to holdings.

Current Positions: DBLTX, SHY, IEF

Sector / Market Recommendations

The table below shows thoughts on specific actions related to the current market environment. 

(These are not recommendations or solicitations to take any action. This is for informational purposes only related to market extremes and contrarian positioning within portfolios. Use at your own risk and peril.)

, RIA PRO: Too Fast, Too Furious – Hedging For A Short-Term Correction

Portfolio/Client Update:

The market continued its melt up this past week, as the Fed’s liquidity infusions continued to fund to equity chase.

As noted in the main body of this missive, the market is extremely overbought which limits our ability to add “broad market” exposures. We are waiting for a brief market pullback or consolidation to add exposure to ETF Models in small and mid-capitalization markets, basic materials, industrials, financials and energy.

We are actively looking to slowly increase our equity exposure modestly to “rent whatever rally” we may get from the “QE-4.”  However, in the short-term we added a “Short S&P 500” ETF position to both the Equity and ETF model to hedge against a correction. 

  • New clients: We are holding off onboarding new client assets until we see some corrective action or consolidation in the market.
  • Equity Model: Bought SDS
  • ETF Model: Bought SDS

Note for new clients:

It is important to understand that when we add to our equity allocations, ALL purchases are initially “trades” that can, and will, be closed out quickly if they fail to work as anticipated. This is why we “step” into positions initially. Once a “trade” begins to work as anticipated, it is then brought to the appropriate portfolio weight and becomes a long-term investment. We will unwind these actions either by reducing, selling, or hedging if the market environment changes for the worse.


A Conservative Strategy For Long-Term Investors

, RIA PRO: Too Fast, Too Furious – Hedging For A Short-Term Correction

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, RIA PRO: Too Fast, Too Furious – Hedging For A Short-Term Correction

If you need help after reading the alert; do not hesitate to contact me.

Current 401-k Allocation Model

The 401k plan allocation plan below follows the K.I.S.S. principle. By keeping the allocation extremely simplified it allows for better control of the allocation and a closer tracking to the benchmark objective over time. (If you want to make it more complicated you can, however, statistics show that simply adding more funds does not increase performance to any great degree.)

, RIA PRO: Too Fast, Too Furious – Hedging For A Short-Term Correction

Click Here For The “LIVE” Version Of The 401k Plan Manager

See below for more details.

Model performance is based on a two-asset model of stocks and bonds relative to the weighting changes made each week in the newsletter. This is strictly for informational and educational purposes only and should not be relied upon for any reason. Past performance is not a guarantee of future results. Use at your own risk and peril.  , RIA PRO: Too Fast, Too Furious – Hedging For A Short-Term Correction

401k Plan Manager Live Model

As an RIA PRO subscriber (You get your first 30-days free) you have access to our live 401k p

 The code will give you access to the entire site during the 401k-BETA testing process, so not only will you get to help us work out the bugs on the 401k plan manager, you can submit your comments about the rest of the site as well.

We are building models specific to company plans. So, if you would like to see your company plan included specifically, send me the following:

  • Name of the company
  • Plan Sponsor
  • A print out of your plan choices. (Fund Symbol and Fund Name)

If you would like to offer our service to your employees at a deeply discounted corporate rate, please contact me.

, RIA PRO: Too Fast, Too Furious – Hedging For A Short-Term Correction

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Lance Roberts is a Chief Portfolio Strategist/Economist for RIA Advisors. He is also the host of “The Lance Roberts Podcast” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter, Linked-In and YouTube
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