The stock market price action has been brutal over the past month and despite what anybody tells you, NOBODY knows what will happen next week, next month or next year. The future is largely unknowable and the stock market (aka the mob) can do anything.
Over the past few years, the stock market has become very volatile with steep uptrends and downtrends and this is due to the fact the market participants have changed i.e. most of the trading these days is now done by machines, computers, algos and short-term traders. So, when a stock is moving higher, prices tend to get pushed up to extremes and when the tide turns and the same stock breaks down, prices tend to get crushed and pushed to the other extremes.
It is notable that these gyrations in stocks have very little to do with fundamentals or business reality but everything to do with momentum and psychology. It should be obvious by now that the market is NOT efficient and nobody can accurately and consistently predict the future. Therefore, predictive market timing cannot and does not work.
Having said all of the above, what if I told you that there is a mathematical, logical and systematic way to hedge your growth stock portfolio and avoid the horrendous drawdowns, pain and angst of stock market downtrends (aka bear-markets)? What if I told you that there is a method which is easy to implement and would have avoided all crashes and bear-markets since the beginning of time? What if I told you that this strategy does not require any predictive powers or an ability to even understand the news, macro factors etc? Would you believe me?
You better believe me because such a strategy does exist and has been used by a few for decades and no, I am not here to sell you anything - only trying to help fellow investors.
This strategy is known as trend following and one which I personally use to manage my own growth stock investment account (by the way, I am a 41-yr old retired money manager).
Trend following does not require any guesswork, predictive abilities and allows this retired person to sleep well at night; and if used diligently and consistently, will help all of you.
But there is a catch - trend following does NOT work all the time; in fact, it does not work most of the time but when it does, boy, it pays out big!
The way trend following works is described below -
You follow two moving averages (shorter-term moving average and a longer-term moving average) and when the shorter-term moving average cuts the longer-term moving average from above; you hedge the market risk by shorting an ETF or futures. When shorter-term moving averages cuts the longer-term moving average from below; you cover your short position and remove the hedge. It is as simple as that; requires a few minutes of work each day and protects one’s investments.
Personally, I use the 10wk/40wk exponential moving average on the NASDAQ100 Index as my trend filter but you can use the 10wk/30wk or 10wk/35wk exponential moving averages; it is entirely up to you.
I have backtested the 10wk/40wk exponential moving average cross on the NASDAQ100 Index going back to 1 January 1988 (30 years) and the results are below -
Total hedging trades = 17, Total losing trades = 15, Total winning trades = 2
Average loss per trade = 5.6%
Average win per trade = 43.5%
Despite the fact that the above crossover strategy only had only 2 winning trades over the past 30 years; it still managed to be profitable! See the figures below:
Buy&Hold (no hedging) - CAGR of 13.15% (maximum drawdown of 85%)
Hedged Strategy - CAGR of 16.1% (significantly reduced drawdowns)
By following the hedged strategy, an investor would have outperformed ‘buy & hold’ by a factor of almost 2!
The way this strategy works is that after a 10-15% decline in the stock market, the trend filter flips to DOWNTREND and one hedges his/her book. The market usually continues to fall for a few days/weeks before reversing higher. During this corrective phase, the losses on the equity longs are more or less largely offset by the gains on the hedges, so the account equity stays flat. When the stock market’s momentum changes, the price charges higher and a few days/weeks later, the trend filter flips to uptrend (which is when you cover your short position).
Normally, the hedging costs around 5.6% of account equity, but this cost is not an out of pocket expense because the long portfolio also goes up with the broad market, so the gains from one’s equity holdings pay for the hedge. However, when a nasty downtrend (bear-market) comes along (and they always do), followers of this strategy make out like bandits!
For example; after the 2000-2002 downtrend in stocks, the hedge produced a gains of 67%! And after the 2008-2008 downtrend, the hedge produced a gain of almost 24%! Note - at the depth of those bear-markets the unrealised gains on those hedges were even larger but by the time the trend filter flipped to uptrend; they had shrunk to 67% and 24%.
Now, most of you on this board are experienced enough to know that hard cash at the bottom of a horrendous bear-market is as good as gold and gives an investor the opportunity to buy shares in quality companies at bargain basement prices. So, imagine having large chunks of hard cash in your account after the 2000-2003 and 2007-2009 bear markets!
Sounds too good to be true? You don’t have to take my word for it; just go to any charting service, pull up the weekly long-term charts of the S&P500 Index or the NASDAQ 100, plug in the above mentioned exponential moving averages and see for yourself.
In practical terms, in order to execute this strategy one needs two things -
- Discipline to take every signal (no second guessing, personal opinion or biases)
- Margin facility in the account; to be able to put on the hedge
For example, if your account equity is $10,000, the day you get the signal to hedge, you would borrow $10,000 on margin and short QQQ. So, if QQQ was trading at $20, you would sell short 500 units of the ETF. If you want to be really cute, you could also calculate the portfolio beta of your investment account and increase/decrease the hedge accordingly but this doesn’t have to be done and can be done at a later date; when one becomes comfortable with this strategy.
The above method is not fool proof (it produces false signals/small losses along the way) but it does protect one’s portfolio from nasty downtrends and over time, the strategy pays for itself as the profits more or less cover the small hedging losses.
So, there you go. Now, you have a reliable and easy method to protect your investment portfolio and improve the quality of your sleep. Best of all; it does not require any predictive powers, bad forecasts, emotions or psychological angst.
When the stock market is trending higher, you remain 100% long but when the seas become treacherous, you hedge your book, put on your life jacket and ride out the storm.
All the best!