The Striking Price

Protection in Volatile Times

With investors increasingly uncertain about the market, volatility may return with third-quarter earnings season. For some it may be time to hedge.

By Steven M. Sears

Saturday, October 3, 2015

Thomas Lee, a New York stock market strategist, recently visited Boston. What he encountered during his investor meetings should give pause to anyone who owns stocks.

Investors told Lee, the managing partner of Fundstrat Global Advisors, that they were having trouble making sense of the market. They said that an absence of economic visibility and a surplus of market visibility (prices falling) were making them nervous.

This suggests that these Boston money managers, a famously stoic bunch, are afraid to buy stocks even if they have a fundamental view that might ultimately give them an advantage over others.

“It feels like someone called fire in a crowded theater. Investors are questioning their framework and assumptions. In their view, ‘markets know something,’ and hence the need for them to step aside,” Lee wrote in a recent client note.

Lee reinforce a view that has been privately discussed at some of the highest levels in the market: No one really knows what’s going on. The Sgt. Schultz style of investing—“I know nothing! I see nothing! I hear nothing!”—seems increasingly prevalent as many investors react to forces largely beyond their control or analysis.

After all, no one really has any insight into China’s economic woes. The same is true for the Federal Reserve, which may or may not raise interest rates before the year is out. Everyone has an inkling about major market forces, but those ideas rarely match the magnitude of the market’s reactions.

Until now, hedging the Standard & Poor’s 500 index has appeared unnecessary. The macro-babble seemed like it would soon sort itself out and cooler heads would prevail.

But at the onset of third-quarter earnings season, Lee’s Boston meetings could prove prescient. If institutional investor sentiment does not improve, earnings season could be volatile.

Lee said his clients are concerned that third-quarter earnings reports will be roiled by China’s economic slowdown and the strength of the U.S. dollar. Those are common concerns, but Lee’s interpretation is not. “In other words, the tape is causing everyone to question their framework,” says Lee.

In the just-ended third quarter, the S&P 500 declined 6.9%, the largest drop since the 2011 third quarter.

INVESTORS WORRIED ABOUT a volatile earnings season can consider hedging their stock portfolios. With the SPDR S&P 500 ETF (ticker: SPY) around $192, investors can buy the November 180 put for $2.25. This protects against a retest beneath the August low of $182.40 and the October 2014 low of $181.40, says Stephen Solaka of Belmont Capital Group.

If the market dips below $180, the put will increase in value. At $170, the profit on the put at expiration is $7.75.

To be sure, some seasoned investors are probably thinking that it’s a great time to buy stocks if a bunch of Boston money managers are complaining they cannot hear the market’s beat. Most of the time, they would be right. But timing is everything.

Each year, usually about now, greed turns to fear on Wall Street. Most everyone in the securities industry starts thinking about their year-end bonuses. This tends to make investors risk-averse, since there’s little time left to reverse bad trades. According to JPMorgan portfolio strategist Dubravko Lakos-Bujas, only 35% of active managers are beating their benchmarks.

If Lee’s takeaways from his Boston investor meetings extend into the earnings season, buyers might not step in to steady stocks that sell off on bad prints, fueling volatility. For this reason, a hedge may indeed help preserve the edge. If you are made of sterner stuff, well, keep calm and trade on.

Reprinted by permission of Barron's Online, © 2015 Dow Jones & Company, Inc. All Rights Reserved Worldwide.

The views expressed in the above papers and articles are solely those of the author of the article, and do not necessarily reflect the views of OIC; the information presented is not intended to constitute investment advice or recommendations to purchase or sell securities of any company; and the information presented is based upon particular events that may or may not recur in the future.

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