Don’t Fight The Tape In 2022 – Hedge The Tape Before It’s Too Late

by Randy Swan of Swan Global Investments, 2/24/22

The 2022 investment year is now well underway and financial advisors and investors would be well advised to not, as the old saying goes, “fight the tape” of what is shaping up to be a difficult year for the stock market.

Fighting the tape is defined as acting in a way that’s contrary to what is usually done when the market is moving in a specific direction. And the tale of the tape in 2022 points to a market headed down with volatility going up. Both the S&P 500 and Nasdaq have entered correction territory this year (with the Nasdaq Composite Index almost in bear market territory from its November high) and Wall Street’s fear gauge, the Cboe Volatility Index, was up 75 percent for the month of January.

Multiple data points and economic realities strongly suggest that investors should run not walk to new risk mitigation strategies and properly hedge their portfolios.

Historically, this was a relatively simple exercise – just move money out of stocks and into bonds. But the bond market is no longer as practical a hedge (unless you want to lose money) as it once was. While already abysmal yields in many bond categories provided negative after-tax income, investors are now faced with similarly abysmal yields today with the specter of a highly inflationary environment and rising interest rates, which would mean a decrease in bond values. Though not a desirable investment strategy, you actually may risk losing less money by holding cash right now rather than holding bonds.

It is important to note, when assessing the stock market, the fact the Federal Reserve may be out of ammunition. The central bank has remained in ‘emergency’ stimulus mode since the 2008 Great Financial Crisis, but the Fed indicates it now expects to raise interest rates three times in 2022. If that sounds manageable to you, consider that Bank of America and Goldman Sachs are forecasting up to seven rate hikes by the Fed this year.

Modern portfolio theory has long espoused a diversified asset mix of stocks and bonds, with a 60% stock and 40% bond model becoming the dominant mix for many portfolios. But today that 60/40 split is a losing proposition on the bond side – and the stock side of portfolios are at significant risk. Many bond categories have proven to be highly correlated to the stocks in recent market crises. So, bonds may fail to deliver on their traditional capital preservation role in a portfolio. Investors and their advisors must now look to adjust portfolio construction and pursue risk-adjusted returns through a lens that is focused on this reality.

It is no surprise then, that the options-trading category is one of the fastest growing investment categories. This category includes hedged equity solutions. Hedged equity strategies may serve long-term investors seeking the benefits of remaining invested in equity while mitigating risk. Hedged equity simply involves buying equity in some form, an underlying investment such as the S&P 500, and then securing a hedge to offset losses connected to market risk.

There are many ways to hedge equity, with one of the most common being options contracts that behave in a non-correlated manner in relation to the underlying equity investment. That non-correlation may provide the portfolio diversification investors desire. While hedging is often considered a short period tactic, long-term investors should consider the benefits of a long-term hedging strategy. This way, they can remain always invested in the market, but always hedged, too. This approach bridges the gap that the traditional 60/40 portfolio may not.

While options are in fact widely used and can be effective portfolio tools for risk management, many investors may be wary of the unknown and instead prefer the status quo of a 60-40 stock-to-bond portfolio or similar. But the reality is that the current economic and interest rate environment handcuffs bonds and therefore requires new portfolio tools to manage risk while pursuing returns.

Financial advisors and long-term investors have made a lot of money over the past decade not fighting the tape – because the tape was clean and green – just let it ride. But now they are facing daunting challenges in the markets not seen for decades – a stock market and inflation-adjusted bond yields in the red. Those who can steward their clients through this redefined investment landscape and provide thoughtful alternatives to address portfolio risks and objectives will benefit immensely. To do so, they must redefine portfolios. The traditional stock-bond combination is for yesterday’s environment. Staying the course is riskier than trying something new.

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Randy Swan is the founder and lead portfolio manager of Swan Global Investments, based in Durango, Colorado.

Don’t Fight The Tape In 2022 – Hedge The Tape Before It’s Too Late

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