Managing Risk in an upside-down world

Another week of craziness in the world, politics, and financial markets. A president steps down in Bolivia, soldiers on the street in Hong Kong, and of course, new all-time highs in some US equity markets. I try not to watch too much TV, but I couldn’t help but check in on a notable financial channel on Friday. I like to do this occasionally just to check in on sentiment and the prevailing narrative. The narrative was exactly as I expected. Basically that stocks will never go down and that NOW is the time to get in. Some things never change. What was particularly hilarious was a money manager saying that one needs to focus on the data rather than politics. It is funny when people opportunistically use extreme price action to rationalize a thesis, or as I like to say, simply “talk their book.” The other irony of the “data” narrative is the only data that really matters is the size of the Fed’s balance sheet and more importantly, how much that balance sheet is increasing due to QE operations.

To me, it feels like we are living in a version of Orwell’s 1984.

War is peace. Freedom is slavery. Ignorance is strength.

In other words, up is down, right is wrong, yes means no. I may sound overly pessimistic in this sense, so to be clear I am actually optimistic about the long term health of the economy. My concern rather is in the short to medium term (6 months to 2 years). Economic policy risk is near all-time highs. Investor complacency is at the most extreme level, ever. Some banks are so starved for liquidity that the Fed actually just increased its newest QE operation, again. I am not here to give you the full “gloom and doom” narrative, however. My preference is to be pragmatic and constructive in the face of uncertainty. Therefore how do we manage these risks? It is not to “sell everything” like many did in 2008/2009. To that point, and to the point of my previous post, it is prudent to “hedge” against a significant downturn. A tool that I recently discovered which is suitable for my needs is the Micro futures contract. This is after using multiple other methods to hedge over the years, all of which have various deficiencies. Options? You deal with time decay unless you are heavily in the money. Sell something short? You run the risk that the shares are called back by the exchange due to scarcity, forcing you to cover at a loss. Leveraged Inverse ETF’s? You lose money every day due to daily rebalancing that has the effect of a permanent time decay. How about regular futures contracts, or minis? Well, the leverage is enormous. One e-mini contract on the S&P 500, for example, has 50x leverage! This means that every point is worth $50 per contract purchased. Wow.

The broader point is that managing risk is not just hedging or identifying the correct thesis, it is also the size of the hedge as a percentage of your liquid assets. Therefore the micro futures contract offers the huge benefit of trading only a slice (1/10th) of the most liquid equity index futures. For example, one point in the S&P 500 equals $5 per contract rather than $50. Below is a snapshot of the most current contracts (December):

I hope this helps alleviate some of the fears and “exoticness” of using futures as an investment tool. It does for me, and I can still sleep well at night!

Disclaimer: This is NOT investment advice, but rather an idea that works for me and my own risk tolerance.

Time to Hedge

Time could be running out on the “everything” bubble

First I would like to explain my lack of posting recently as it is not for a lack of topics or opinions. My older son just had fall break, and we used the time off as an opportunity to travel to Florida for several days. The 80-degree weather was a nice respite from the cold in the midwest and the kids had a blast as usual. The resort we stayed at was great, and we gutted out one day at Epcot since we already did Magic and Animal Kingdom back in February. We also closed on a property that we had owned for almost 14 years (love the “mobile” closes). It was bittersweet due to the memories of living there, rehabbing the property, fixing things, and tenant issues (lol). Recently a tenant moved to Arizona, and I decided that I didn’t want to manage from afar or hire a management company. In addition, the market in Grand Rapids has been very hot which manifested itself in competing bids on our property (basically a bidding war over list price). A nice problem to have I suppose.

I would like to think that we are selling at the top and that my instincts are prescient. Maybe, but things usually happen due to a confluence of events and the timing becomes coincidental when looking through a rearview mirror. In other words, luck plays a big part. Luck aside, I do have a sense of foreboding regarding the current social, political, and economic situation which influenced my decision to sell. Whether it is quantitative indicators that I follow, civil unrest throughout the world, or simply conversations I have with people every day, “things” just don’t feel right. Of course, I could argue that it has been that way for a while. With this mindset, selling the property was just one step, and I have also started layering in “hedges” to protect my assets. Translation: I am building hedged positions (short) in the equity markets. A hedge is different in that it is not a primary investment, but rather a bet to protect those investments. Call it insurance. If you want to play at home, I shorted the Nasdaq and will layer in more shorts next week. Yes, I am fighting the Fed and realize it may be fruitless, but my take is that the Fed’s omnipotence will come to an end soon. When that happens, look out below. Aside from monetary policy reaching its limits, I believe we are at a bifurcation point politically which could have profound implications on fiscal policy, and life in general. In short, we are becoming a banana republic and anything can happen.

Disclaimer: This is NOT Investment advice. I am just sharing my thoughts and what I am doing.