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TMFPostOfTheDay (< 20)

Sensible to Sit Out the Rally?



August 09, 2013 – Comments (1) | RELATED TICKERS: BRK-A

Board: Berkshire Hathaway

Author: mungofitch

A rambling post.

First, a couple of quotes. " A role can be performed by the stock index future contract in  aiding the risk-reducing efforts of the true investor. An investor may  quite logically conclude that he can identify undervalued securities,  but also conclude that he has no ability whatsoever to predict the  short-term movements of the stock market. This is the view I maintain  in my own efforts in investment management. Such an investor may wish  to ''zero out'' market fluctuations, and the continual shorting of a  representative index offers him the chance to do just that. Presumably, an investor with $10 million of undervalued equities and a constant  short position of $10 million in the index will achieve the net rewards  or penalties attributable solely to his skill in selection of specific  - securities, and have no worries that these results will be swamped --  or even influenced -- by the fluctuations of the general market.  Because there are costs involved -- and because most investors believe that, over the long term, stock prices in general will advance -- I think  there are relatively few investment professionals who will operate in  such a constantly hedged manner. But I also believe that it is a  rational way to behave and that a few professionals, who wish always  to be ''market neutral'' in their attitude and behavior, will do so..." --Warren Buffett, excerpt from March 1982 letter to the chairman of the house  subcommittee on oversight and investigations, the committee then debating whether to allow the introduction of stock index futures trading. (Mr B said "don't", and they did anyway)

Now, a bit of homework following this link Basically a very cogent indication of the proposition that the broad US market is very overvalued at the moment, and more importantly what the current fair value might be estimated at. It's updated regularly.

Lastly, another quote: "What the wise do in the beginning, fools do in the end" --Also Mr Buffett, apparently quoting a Spanish proverb

I mention these because I think I may have spotted an exception to the proverb. As is well known, Mr Watsa of Fairfax Financial is fairly concerned about economic circumstances that might lead to a major equity meltdown, so quite a while back he added essentially 100% hedging to the firm's equity portfolio.  This may well have been very prudent and may well work out extremely well, but it has not yet given the firm an advantage because prices have been rising. Thus, doing it then might well have been smart, but doing it now would be only almost as smart, but much luckier. It's Mr Watsa's trade without the unrealized losses to date.

My thinking is this: contrary to the proverb, adding such a hedge is more and more compelling an alternative as the bull market rolls on. Though we have been taking more risk by delaying, having delayed means that the entry price for such hedges gets better and better.

For those unfamiliar with the mechanisms, shorting the index by selling S&P index futures and rolling them as needed is essentially zero cost on an ongoing basis if the index is flat in nominal terms. It loses money if the market rises and vice versa, in direct proportion. This is very unlike protective put options in that there is no ongoing cost.

So, the proposition: Imagine using short index futures exactly as described by Mr Buffett in the first quote, starting today. Sell whatever number of index contracts, whichever indices you like, to hedge your portfolio starting now. Keep an eye on that web site. Close all the hedges the next time the broad US index is fairly valued on at least one of those metrics, which might be a number of years. Then never hedge again, at least not until the next time the market is so hugely overvalued.

I raise this to post the following question: what's the downside? Only if the market remains overvalued relative to its multi-century historical average continually forever does this end up costing you money. In that case you would not participate in the long run growth of equities, but only in the amount by which your own selections beat the index. But to me that outcome seems unlikely in the extreme, and surprisingly survivable.

In all other circumstances the outcome is: - The volatility of your portfolio's mark-to-market value immediately plummets to near zero. - You still get the extra upside of everything you own that's market beating - You get a one-time profit of about 1/3 your current portfolio value, realized at an unknown date in the future. - Your final profit is very slightly lower the longer it takes, because  inflation increases the nominal index value bit by bit over time, and because real trend earnings rise gradually over time.

As a concrete example, imagine it takes 5 years more before the S&P next passes through fair value, fair value of the index is about 1000 now, inflation is about 2% in the interim, and trend real earnings rise at their usual rate of around 1.75%/year. At the end of five years fair value would be around S&P 1204. The index hits that, and you close the shorts. End result? You'd have five years of essentially zero portfolio value volatility and an increased return of an extra 5.2%/year for five years. Those are both very good things.

How long would one have to wait? Might be a month, might be a long time. For whatever it's worth, using a few simplifying assumptions, the  longest continuous stretch of overvaluation for US equities since 1871  was 218 months (18.2 years) ending Q1 2009. Overvaluation restarted again Q2 2009. Prior to that stretch, the longest-ever period of continuous  overvaluation was 142 months (11.8 years) ending April 1970. The next longest stretch was the 11 years ending mid 1896.

It seems to me that if you buy the proposition that there will again be a day that the broad US market trades at its historical average valuation level or below, any investor with the patience, rationality, and wherewithal should consider doing what Mr Watsa has done. I suspect very few investors will, as very few could stand the idea of missing out on an index rally no matter how sensible it is to sit this one out. But the hyper-rational investors will consider it.





1 Comments – Post Your Own

#1) On August 10, 2013 at 12:57 AM, awallejr (35.47) wrote:

I will be honest.  I truly don't understand how playing futures will make my portfolio net cost neutral.  Seems like a yield portfolio in theory would benefit but I don't understand the mechanics.

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