The Market's Up, The VIX Is Down, But Risks Abound

Bears Drowning In Sea Of Green

"'Sea Of Green;: Bears Crushed As Stocks Storm Above 50% Fib Retracement"

That ZeroHedge headline from Friday's close would have seemed unlikely a few months ago, when former Fed wunderkind Zoltan Pozsar warned that the Fed needed stocks to fall further to fight inflation. Yet here we are, with stocks climbing back above key technical levels, and the S&P VIX Index falling below 20 after hovering in the low 30s in early June. 

Screen capture via ZeroHedge

Fortunately, the new factor we added to our security selection process near the end of June has weathered the fib retracement well. As we mentioned in an investing note in a post at the time (A Rough Week For The Establishment), these were our top ten names on the first date we added the new factor: 

Screen capture via Portfolio Armor on 6/24/2022.

Here's how they've performed so far, versus the SPDR S&P 500 Trust (SPY): 

Despite that, risks abound. To begin with, as ZeroHedge concludes in that post, the Fed probably will need to hammer stocks after all. 

[T]he Fed will have to aggressively step in and contain the market's froth which has undone the tightening from the latest 150bps of Fed rate hikes...

... leaving Powell with no other choice than to hammer markets at the first possible opportunity

But Risks Abound

But consider also the geopolitical risks bubbling up this month: 

  • Rising tensions with China, in the wake of House Speaker Nancy Pelosi's visit to Taiwan. While we have so far avoided military conflict with China, despite the U.S., China, and Taiwan scrambling fighters during Pelosi's flight, Chinese state media has warned of repercussions. 

    #GTVoice: China can calmly decide how to punish Pelosi based on the investigation results, striking precise blows step by step and making Pelosi fully feel the lasting pain and loss of Chinese sanctions.

    — Global Times (@globaltimesnews) August 11, 2022
    What if China's method of striking back at Speaker Pelosi is to target one of her state's flagship companies? Consider the vulnerability of Apple Inc. (AAPL) with 95% of its manufacturing currently being done in China.

  • Escalation in the Ukraine War. Ukrainian forces reportedly have been shelling the Zaporizhzhia nuclear plant, which is larger than the old Chernobyl plant, and is currently occupied by Russia. 

    💬 #Nechaev: In the past few days, Ukrainian units have shelled the territory of #Zaporozhskaya NPP, which constitues an act of nuclear terrorism.

    ☝️ We expect that the global community and competent international bodies will pay due attention to the unfolding catastrophe.

    — MFA Russia 🇷🇺 (@mfa_russia) August 12, 2022
    For those wondering why I've embedded a Russian government tweet about this above: it's hard to find Western media sources acknowledging that Ukrainians are shelling this plant, though the New York Times doesn't deny the Russian claims, instead reporting vaguely that the plant has been caught in the middle of the conflict. Similarly, U.S. Undersecretary of State Jenkins, in her remarks at the UN Security Council meeting requested by Russian on Thursday, didn't deny that the Ukrainians were shelling the plant either. In both cases, the desire of the U.S. establishment to avoid putting the Ukrainian government in a bad light (as evidenced by, for example, CBS backtracking on its documentary about Ukrainian corruption) has obscured where the shells are coming from, which seems like something the U.S. government ought to be able to determine (and logic suggests that the Russians wouldn't want to shell the plant their troops are occupying). Nevertheless, the prospect of a nuclear disaster there seems like another risk the market is ignoring.

  • Tensions Rising in the Balkans. This one may have flown under your radar with all the rest happening, but at the beginning of August, Serbia and Kosovo were on the verge of a shooting war over a Kosovar law about to be enacted that would have impacted Serbs living there. Kosovo decided to push the implementation of the law back a month to September, so we have a potential flare-up there to look forward to next month. 

  • Rising political tensions in the U.S. due to the FBI raid on Trump, and reactions to it. 

Taking Advantage Of Lower Volatility To Limit Your Risk

Here's a simple way of protecting a $500,000 stock portfolio against market risk using optimal, or least expensive, puts on SPY. You can use this approach with a $50,000 portfolio or a $5,000,000 portfolio too: just adjust the dollar amount you use in Step 1. For the purposes of this example, we'll assume your portfolio is closely correlated with SPY, that you have enough diversification within it to protect against stock-specific risk, and that you can tolerate a decline of up to 20% over the next few months (if you have a smaller risk tolerance, you can use the same approach entering a smaller decline threshold).

Step 1

Divide $500,000 by the current price of SPY, which was $427.10 as of Friday's close, to get 1,171 (rounded).

Step 2

Scan for the optimal, or least expensive, puts to protect against a >20% decline in 1,171 shares of SPY over your desired time frame. Here, I've used the end of the year, but you try any available options expiration.

Optimal Put on SPY

This and the subsequent image are screen captures from the Portfolio Armor iPhone app

Note the cost here: $7,854 or 1.57% of portfolio value, which was calculated conservatively, using the ask price of the puts (in practice, you can often buy options at some price between the bid and ask prices). That worked out to an annualized cost as a percentage of portfolio value of 4.12%.

Step 3

Round up the number of SPY shares to the nearest 100 and repeat step 2.


Optimal Put on SPY

Note that, in this case, it was cheaper to hedge rounding up to the nearest round lot: The cost was $5,652, calculated conservatively again, at the ask. That's about 1.1% of a $500,000 portfolio, or 2.9% annualized. Might be worth it if you're worried about the Fed smashing down stock valuations. 

What About Your Bonds? 

You can use the same approach as above, substituting a bond proxy for SPY. So, for example, the iShares 20+ Year Treasury Bond ETF (TLT) for long-dated U.S. government bonds, the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) for corporate bonds, etc. 

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Disclaimer: The Portfolio Armor system is a potentially useful tool but like all tools, it is not designed to replace the services of a licensed financial advisor or your own independent ...

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