Any natural hedges to stocks?

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steve321
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Any natural hedges to stocks?

Post by steve321 » Wed Oct 10, 2018 3:54 pm

Came across this interesting tweet by Mohamed A. El-Erian
As unsettling as a #Dow 600 point drop is for #investors, there's a 2nd notable issue today: Few "natural hedges--across and within market segments -- are providing protection. This shouldn't come as a big surprise given how much markets have been distorted in the last few years.
Basically with rates going up, bonds are falling at the same time as stocks. Mohamed A. El-Erian speaks of 'few' hedges, but I see none, really. Do you?

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Raybo
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Re: Any natural hedges to stocks?

Post by Raybo » Wed Oct 10, 2018 4:02 pm

Hedges I see:

Cash - A dollar is always worth a dollar regardless of stock and bond values.

IBonds - don't go down in value when interest rates rise. Still grow with inflation.

Puts - cost money to hold but do well in down markets.
No matter how long the hill, if you keep pedaling you'll eventually get up to the top.

zeugmite
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Re: Any natural hedges to stocks?

Post by zeugmite » Wed Oct 10, 2018 4:18 pm

Positive yielding hedges? Probably only cash at this point.

alex_686
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Re: Any natural hedges to stocks?

Post by alex_686 » Wed Oct 10, 2018 4:24 pm

I would go with direct holdings of real estate. Positive return and a correlation around 0 to stocks. Last point is debatable, but that is where I stand.

aristotelian
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Re: Any natural hedges to stocks?

Post by aristotelian » Wed Oct 10, 2018 5:28 pm

Bonds are still probably your best bet. If we enter a true bear market, interest rates will go back to zero and bonds will go up. Sometimes they correlate but overall the correlation is zero. You can also buy individual bonds if you don't like seeing the price drop when rates rise.

WhiteMaxima
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Re: Any natural hedges to stocks?

Post by WhiteMaxima » Wed Oct 10, 2018 5:30 pm

CDs, cash.

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Re: Any natural hedges to stocks?

Post by iamlucky13 » Wed Oct 10, 2018 5:46 pm

What prompted the tweet? Did the Dow drop 600 points today or something? Should I be unsettled by this one day drop?

I'm asking rhetorically, but I suppose there is a legitimate Bogleheads take on the question focused on time frames that Bogleheads are actually interested in.
Raybo wrote:
Wed Oct 10, 2018 4:02 pm
Cash - A dollar is always worth a dollar regardless of stock and bond values.
Technically true, but what about when that dollar is used to buy something that has a price affected by exchange rates, like gasoline?

WhiteMaxima
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Re: Any natural hedges to stocks?

Post by WhiteMaxima » Wed Oct 10, 2018 5:51 pm

CDs, cash. keep in mind cash is another form of asset class. When fed tight the balance sheet and raise the interest, cash (US$) becomes a hot commodity.

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Re: Any natural hedges to stocks?

Post by nisiprius » Wed Oct 10, 2018 5:58 pm

Paying attention to direction and ignoring magnitude is a mistake.

To say "bonds and stocks are falling at the same time" is to miss the forest for the trees.

Today, the S&P fell 3% while bonds, as represented by the Vanguard Total Bond Market Index ETF, BND...
...it appears to me that they didn't fall at all.

Image

Over the last ten days, stocks fell 4.5% while bonds fell 1%.

Image

If by "hedge" you mean a way of getting the returns of stocks without really taking the risks of stocks, if you mean some magic investment that will simply cancel out stock plunges, I think that's the investing equivalent of perpetual motion.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

ge1
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Re: Any natural hedges to stocks?

Post by ge1 » Wed Oct 10, 2018 6:49 pm

I bought some puts on some of the highflying tech stocks, but that is only gambling money. The best hedge is cash, especially when it is yielding 2 - 2.5%...

hdas
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Re: Any natural hedges to stocks?

Post by hdas » Wed Oct 10, 2018 7:34 pm

Here's AQR paper on the issue https://www.aqr.com/Insights/Research/A ... -Drawdowns

Diversification During a Century of Drawdowns

Image

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steve321
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Re: Any natural hedges to stocks?

Post by steve321 » Thu Oct 11, 2018 12:00 am

nisiprius wrote:
Wed Oct 10, 2018 5:58 pm


If by "hedge" you mean a way of getting the returns of stocks without really taking the risks of stocks, if you mean some magic investment that will simply cancel out stock plunges, I think that's the investing equivalent of perpetual motion.
By hedge I mean something with a low or negative correlation to stocks. My understanding is that when stocks take a dive, there's generally a flight to safety, which makes bonds go up.
Now instead rates go up (pushing the price of bonds down) and at the same time stocks prices fall. Indeed some people argue that stocks are falling because rates are going up.

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Re: Any natural hedges to stocks?

Post by Valuethinker » Thu Oct 11, 2018 5:29 am

steve321 wrote:
Thu Oct 11, 2018 12:00 am
nisiprius wrote:
Wed Oct 10, 2018 5:58 pm


If by "hedge" you mean a way of getting the returns of stocks without really taking the risks of stocks, if you mean some magic investment that will simply cancel out stock plunges, I think that's the investing equivalent of perpetual motion.
By hedge I mean something with a low or negative correlation to stocks. My understanding is that when stocks take a dive, there's generally a flight to safety, which makes bonds go up.
Now instead rates go up (pushing the price of bonds down) and at the same time stocks prices fall. Indeed some people argue that stocks are falling because rates are going up.
Rising interest rates are usually bad for stocks (some sectors) although not necessarily for the market as a whole.

In 1994 the long US Treasury fell 30% from memory (the zero coupon bond). Stocks were down about 8%. It was a pause in a decade long bull market.

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nisiprius
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Re: Any natural hedges to stocks?

Post by nisiprius » Thu Oct 11, 2018 5:55 am

steve321 wrote:
Thu Oct 11, 2018 12:00 am
nisiprius wrote:
Wed Oct 10, 2018 5:58 pm
If by "hedge" you mean a way of getting the returns of stocks without really taking the risks of stocks, if you mean some magic investment that will simply cancel out stock plunges, I think that's the investing equivalent of perpetual motion.
By hedge I mean something with a low or negative correlation to stocks.
Low correlation isn't a hedge at all. Zero correlation isn't a hedge at all. The benefits of low correlation are subtle and hard to understand--basically, honors student in high school math--so they are "explained" with misleading language and explanations.
My understanding is that when stocks take a dive, there's generally a flight to safety, which makes bonds go up.
Your understanding is seriously flawed and you need to take a look for yourself at what really has happened.

1) The correlation between stocks and bonds has been close to zero, not negative. Some negative correlation has been observed over the last decade or so but I wouldn't bank on it.

2) Not all bonds have shown the "flight to safety" effect. The mixture of bonds in the Vanguard Total Bond Market Index Fund, for example, is almost a straight line during the period of the 2008-2009 stock crash. No dip, no bulge. Investment-grade corporate bond funds took a 10% hit. The "flight to safety," if that is really what has been occurring, has been pretty well limited to Treasuries.

3) Most important, the "flight to safety" effect has been weak. During 2008-2009, if you'd been in an intermediate-term Treasury fund instead of Total Bond, you'd have seen a little 6% or 10% bulge (depends how you measure). But you would have paid for this, over history, with a noticeably lower return. And it was only 10%.

Blue, total bond. Orange, intermediate-term Treasuries. Green, stocks.

Source

Image

That's about as good an example of a "flight to safety in Treasuries" working, and certainly it's nicer to have a +10% gain than a -50% loss, but that's not much of an offset.

You can get more by going to long-term bonds but that has serious problems of its own, specifically inflation risk.

I just consider bonds as a sea anchor, and that seems valid. In order to treat them seriously as a "hedge" that will counteract stocks and not just dilute them, you would need to be holding a portfolio in the neighborhood of 15/85 or 20/80 to get a portfolio without much drop in 2008-2009. Of course, some investors really do this, it's part of a risk parity strategy, but that comes a long with a ton of other baggage, including a lot of leverage to make up for the low return of bonds.

And all this assumes that the negative correlation isn't just a chance sampling accident and that it will continue into the future.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

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Re: Any natural hedges to stocks?

Post by Valuethinker » Thu Oct 11, 2018 8:10 am

nisiprius wrote:
Thu Oct 11, 2018 5:55 am


And all this assumes that the negative correlation isn't just a chance sampling accident and that it will continue into the future.
Another way of saying this might be:

- the causes of each bear market are different.

The 2008-09 was a repricing of risk assets due to falls in the US housing market, which became an all out meltdown once Lehman Brothers entered bankruptcy, undermining any confidence in institutions with credit risk. Which was followed by the Eurozone Crisis over Greek sovereign debt.

The 2000 one was a collapse in valuation of internet related tech media and telecoms stocks.

The 1990 one was a combination of the S&L debacle and fallout, the end of the 1980s boom and Saddam Hussein's surprise invasion of Kuwait and temporary oil price spike. You also had the arrest of Michael Milliken and the collapse of the junk bond market. The fall in post Cold War defence spending exacerbated it particularly in California (see the Michael Douglas movie "Falling Down").

The 1994 bond market rout was about Alan Greenspan tightening monetary policy faster than was expected - interest rates having only gone down up to that point.

1987 was a stockmarket crash associated with Portfolio Insurance - a hedging technique that didn't hedge. Markets closed up for the year.

If you look at the 1970s you see equity and bond markets go down together:

- an adverse macroeconomic shock (typically commodity price spikes around the time of the 1973 Arab Israeli War, and the 1979-80 Iranian Revolution; which caused a sudden contraction in oil supply and unleashed inflationary forces into the economies)

So in those cases you had inflation up but economy down. The first bad for bonds, the second bad for stocks. Then the failure of Central Banks to bring inflation under control, so a threat of even higher interest rates on the next cycle.

US Treasury Bonds are priced by the interest rate cycle - in effect, Fed policy actions. Corporate bonds also have an element of correlation with equity risk.

So it depends what is actually causing the bear market in stocks, and whether that impacts bonds as well.

understandingJH
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Re: Any natural hedges to stocks?

Post by understandingJH » Thu Oct 11, 2018 9:08 am

nisiprius wrote:
Thu Oct 11, 2018 5:55 am
steve321 wrote:
Thu Oct 11, 2018 12:00 am
nisiprius wrote:
Wed Oct 10, 2018 5:58 pm
If by "hedge" you mean a way of getting the returns of stocks without really taking the risks of stocks, if you mean some magic investment that will simply cancel out stock plunges, I think that's the investing equivalent of perpetual motion.
By hedge I mean something with a low or negative correlation to stocks.
Low correlation isn't a hedge at all. Zero correlation isn't a hedge at all. The benefits of low correlation are subtle and hard to understand--basically, honors student in high school math--so they are "explained" with misleading language and explanations.
My understanding is that when stocks take a dive, there's generally a flight to safety, which makes bonds go up.
Your understanding is seriously flawed and you need to take a look for yourself at what really has happened.

1) The correlation between stocks and bonds has been close to zero, not negative. Some negative correlation has been observed over the last decade or so but I wouldn't bank on it.

2) Not all bonds have shown the "flight to safety" effect. The mixture of bonds in the Vanguard Total Bond Market Index Fund, for example, is almost a straight line during the period of the 2008-2009 stock crash. No dip, no bulge. Investment-grade corporate bond funds took a 10% hit. The "flight to safety," if that is really what has been occurring, has been pretty well limited to Treasuries.

3) Most important, the "flight to safety" effect has been weak. During 2008-2009, if you'd been in an intermediate-term Treasury fund instead of Total Bond, you'd have seen a little 6% or 10% bulge (depends how you measure). But you would have paid for this, over history, with a noticeably lower return. And it was only 10%.

Blue, total bond. Orange, intermediate-term Treasuries. Green, stocks.

Source

Image

That's about as good an example of a "flight to safety in Treasuries" working, and certainly it's nicer to have a +10% gain than a -50% loss, but that's not much of an offset.

You can get more by going to long-term bonds but that has serious problems of its own, specifically inflation risk.

I just consider bonds as a sea anchor, and that seems valid. In order to treat them seriously as a "hedge" that will counteract stocks and not just dilute them, you would need to be holding a portfolio in the neighborhood of 15/85 or 20/80 to get a portfolio without much drop in 2008-2009. Of course, some investors really do this, it's part of a risk parity strategy, but that comes a long with a ton of other baggage, including a lot of leverage to make up for the low return of bonds.

And all this assumes that the negative correlation isn't just a chance sampling accident and that it will continue into the future.
Here's a thought experiment Nisiprius. Which of the following portfolios would you rather have? And can you guess which assets make up these portfolios?

Image

hdas
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Re: Any natural hedges to stocks?

Post by hdas » Thu Oct 11, 2018 2:51 pm

steve321 wrote:
Wed Oct 10, 2018 3:54 pm
Came across this interesting tweet by Mohamed A. El-Erian
As unsettling as a #Dow 600 point drop is for #investors, there's a 2nd notable issue today: Few "natural hedges--across and within market segments -- are providing protection. This shouldn't come as a big surprise given how much markets have been distorted in the last few years.
Basically with rates going up, bonds are falling at the same time as stocks. Mohamed A. El-Erian speaks of 'few' hedges, but I see none, really. Do you?
Check this thread: viewtopic.php?f=10&t=255985

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nisiprius
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Re: Any natural hedges to stocks?

Post by nisiprius » Thu Oct 11, 2018 6:25 pm

understandingJH wrote:
Thu Oct 11, 2018 9:08 am
Here's a thought experiment Nisiprius. Which of the following portfolios would you rather have? And can you guess which assets make up these portfolios?

Image
OK, I'll play. In hindsight, and assuming 1/1/2008 as the starting point, I would rather have had Portfolio 1, and in a second I'll give my guesses as to what they might be.

But in return, I would like to ask you the following question: do you have anything dated, in writing, that shows that you personally invested in, or recommended, portfolio #1 on about 1/1/2008?

So my guess is that Portfolio 2, red, is "the stock market," i.e. S&P 500 or Total Stock; that portfolio 3, yellow, is a balanced portfolio of, perhaps, 60/40 stocks/bonds; and that portfolio 1 is a stock sector fund, or some other narrow stock category, that, we know now in 2018, didn't suffer much during 2008-2009. I'm guessing that portfolio 1 is pure stocks because the slope of the line after 2010 parallels the red line.

Second guess: portfolio 1 includes long term nominal Treasuries.

OK, what are they?
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

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