To hedge, or not to hedge, that is the question:
Whether ’tis nobler in the mind to suffer
The slings and arrows of outrageous drawdown,
Or to take arms against a sea of volatility
And by opposing end them, to hedge….
— With Apologies to William Shakespeare
I could have carried on with this re-lyric of one of the most famous passages in the history of the written word, but even I have trouble improving on Willie Shake. So I reckon I’ll leave it where it is.
Besides, I think we’ve hit the crux of the issue: “to hedge or not to hedge?”. That is indeed the question upon which I wish to focus this week’s visit. It has been an important one for about as long as I can remember, and the matter is particularly prominent at this current pass in our affairs.
I must admit that I’ve had an historic, philosophical bias against hedging, but then again, Shakespeare/Hamlet himself stated that “there are more things in heaven and earth, Horatio, than are dreamt of in your philosophy”. (Act 1, Scene 5 167-8). And though I never actually knew Horatio, I suppose that what applies to the H boys also applies to the rest of us.
Now, that the hedge has many alluring attributes (ones that we need not inventory in our limited little space), there is little doubt. But applying them to your net advantage is a tricky and nuanced exercise. When first considered (e.g. in times of market unrest), it has a siren-like appeal. But that, of course, is when the hedge is at its most expensive. Moreover, while putting hedges on is often an intuitive exercise, disposing of them is another matter entirely. They often suffer from benign neglect, and (especially when they take the form of limited life derivatives), they end up, on balance, costing us. In retrospect, we wonder why we bothered with them in the first instance. And we swear ourselves off of them, only to return to their warm embrace the next time our portfolios show any signs of the squick.
My main problem with them is two-fold. First, as one of my core tenets of risk management, I have always felt that if one wishes to undertake risk reduction, one is better off removing line items from one’s portfolio than adding to them. However, perhaps more germane to our current conundrum our tendency to fixate on the hedge at the wrong times. It is only when the market goes all wobbly, and hedging becomes our obsessive focus, that we tend to act. We pay up for doing so. And we pay the price.
Conversely, when the investment markets are calm, and the hedge can be had, on a relative basis, for a song, we are inclined to ignore it. More generally, my main frustration with hedging, as I’ve expressed many times before, is that when it comes to the hedge, everything our mamas and papas (who, don’t you know we’re driving insane?) taught us about buying low and selling high goes out the window. Instead, we tend to overpay for the hedge (whatever form it assumes), rid ourselves of it at bargain basement prices (if indeed we rid ourselves of it at all), and ignore it entirely when it is on sale.
And it may just now be the case that the hedge is indeed on sale, at least on a relative basis. Consider, if you will, the recent pricing activity of the VIX, that benchmark of options volatility that is the widely accepted proxy for how investors (through the options markets) are pricing in risk. With little notice, it went into free fall over the last few sessions:
Careful observers may wish to note that at 14 ¼, it resides within realms witnessed during surges to all-time highs on the Gallant 500, as well as that period of relative innocence we experienced in late April, before the Trump Tweet Trade War began to rage in earnest. It also down ~40% from its >24 peak in early August, when a bunch of other bad sh!t was going down.
Now, I ask you: is the world really 40% less risky than it was 8 weeks ago? Please, if so, explain to me how. The China trade psychodrama continues to play out in ambiguous fashion, and shows no signs that an end similar to the close of Hamlet, Act V is not a real possibility.
The Washingtonian escapades appear to be, if anything, escalating. And if, for the time being, investors are taking on a “not my monkeys; not my circus” vibe to this, it doesn’t mean they’re right to do so. Earnings are still looking pretty dismal (though we’ll be much better informed on that score a week hence, after such luminaries as Amazon and Microsoft report). China just printed its worst GDP quarter in a generation, and our own economy is hardly showing much chest-bumping mojo.
So anyone who might be worried enough about these goings on to pursue the hedge would arguably be justified in these latent thoughts – at a point when the price, at least in options space, of putting it on is actually on the decline. I doubt many of you will take this step, though, and this is the type of thing that drives me (along with your momma and papas) insane. Last Christmas, when the VIX, at >36, was more than 2.5 times as expensive as it is now, my yuletide phone was ringing off the hook with requests for my assistance how best to secure these here hedges. It was, by contrast, radio-silent during the subsequent, Fed-induced rally. Lots of calls in the horrific month of September ’19; almost none coming my way at the moment.
So I’m here to tell you that if the hedge is your jam, in options space, now might be a good time to take a little looksee at how to rock one. And all of this, of course, is to say nothing of my own current hedge obsession: the one involving the purchase of Madame X (US 10 year) to offset exposure to the equity markets. I haven’t looked like a hero with my call of a couple of weeks back that associated rates were going to zero. Quite to the contrary; I’ve looked like The Monkey in My Circus. At 1.75% and change, we’re looking at multi-week highs on yields/lows on price. And it’s not just longer-dated U.S. paper that has sold off/manifested higher yields. It’s my sad duty to report that it’s a global phenomenon. If you doubt this, just take a gander at the rate action in Denmark, which happens to be Hamlet’s home turf:
Something’s Rotten In the State of Denmark: Danish Rates Soar to -0.36%
Had everyone not died at the end, Hamlet would have been king, even some 400 years later, he might have been less of a Gloomy Gus knowing that he was able to 36 basis points to any of his good subjects for the honor of lending him money.
On the other hand, he might have eschewed debt altogether, especially if he followed the advice that one of his victims (Polonius) gave to another recipient of his capricious blade (son Laertes): “neither a borrower nor a lender be”.
But no one is listening to these dead guys now. Everyone is borrowing, and will continue to do so. But I don’t choose to view that as being in any way dilutive to my hypothesis that rates – particularly in the United States are — gonna sink like a stone some of these days. And whether by cause or effect, this will transpire contemporaneous to a decline in the U.S. equity markets.
And again if you think there’s any framework for embracing a hedge of this nature at all, now might be a good time to take the plunge. It’s priced attractively, the pending slew of data (earnings, GDP, Fed decision, etc.) all provide hopeful catalysts, and I just don’t see how you can do better, hedge-wise.
It may also be the case that the FX markets are telegraphing such an expectation. The USD had a largely unremarked but nonetheless noteworthy slide these past few days:
We should also bear in mind that the British Pound, Willie Shake’s home currency, is prominently featured in this basket. It shot up 7 rocket-like handles in the wake of an announced Brexit deal that may not happen and in fact probably won’t. More likely, old school financial economic assumptions suggest the FX market is anticipating lower equity prices/yields on these here shores. And I’m here to tell you that like the Chairman once sang about Love and Marriage: you can’t have one without the other.
So: to hedge or not to hedge? At the end of the day, I can’t make that call for you, but rather can only opine that there would be worse times to contemplate such a move than right at present. Further, I should remind you that no matter what you do, the hedge may not serve you. It won’t for instance, be of much use if you hit a pedestrian a rainy rush hour afternoon on 34th Street. It does nonetheless have some merit, and, in the final analysis, I’d rate current hedging conditions a solid 8 ½.
At the end of the day, you’re going to have to make your own judgments in this regard. I am happy to weigh in, but it’s your call, and it’s a matter of personal disposition as much as it is one of appropriate portfolio management. You could, however, do worse than adding that other bit of insight Polonius gave to his boy Laertes on the occasion of their final encounter. “To thine own self be true”.
Hedge or no hedge, this sure seems like good advice to me.
TIMSHEL