Apple as the New Safe Haven? Please.

The markets were down again today on European concerns, but they did manage to pare very large intraday losses and make a run for positive territory on some indices late in the trading day. One of the interesting things that seemed to fuel the run was a surge in Apple stock, which is now almost 15% of the Nasdaq 100. The stock ended the day up almost three percent, and at a new 52 week high, closing at $411.63. Puzzled at why Apple was moving up on this mostly glum Monday, I checked our Bloomberg to see if something earnings- or guidance-specific had hit. That wasn’t the case, but there were some notes about Steve Jobs delivering a future speech, and the possibility of the company joining the cloud computing revolution, which may justify the move. Sean also mentioned that the chatter he was hearing and reading was that Apple was being bought as the new safe haven.

Gold has gone parabolic, and treasuries are arguably priced for a recession/deflation. Corporate earnings have been healthy and U.S. balance sheets have a lot of cash. But a large cap tech stock as a safe haven? Goodness gracious, I believe Mr. Market has been watching too much Cramer lately.

Right now tech stocks are staging a pretty good rally, and that is a developing technical positive that needs to be balanced against the many negatives in the backdrop. That being said, I think any investors considering buying Apple stock as a safe haven ought to think not twice, but maybe three, four and five times about what they’re doing. Attractive hedges are in demand these days, but despite the temptation to buy into this story, we’ll stick with boring old treasury bonds, gold, and the dollar as decent hedges in this environment. Apple is hot, trendy, and has been a very nice investment since 2009. But Apple as the new safe haven? Please.

Trim the Hedges?

At the moment we have concluded as a firm that the higher probability is that we are in a new bear market rather than a severe correction like we witnessed last year. Therefore we have been busily crafting and re-crafting strategies to deal with this hostile period for the market. Luckily we have some hedges in the portfolio that are providing the exact inverse qualities to the stock market that we expected from them. Specifically, gold and long-term Treasury bonds have been our most productive hedges during the latest sell-off, and we have definitely been rewarded for holding these positions in our portfolios to date.

But looking backwards at performance is always dangerous. Both of these assets are very volatile, and contain their own risks. So as we’ve been setting stops and removing equity risk in portfolios, we are faced with a decision as to whether we should trim our hedges and lock in some gigantic gains in the process. On the one hand it is very tempting to take the latest run up in gold or long maturity bonds and sell them to cash right here. It seems like you can’t lose with a huge win booked, right? The downside would be if the bear market intensifies, and we now have less of these hedges to help defend in our portfolios. It’s a tough choice, and one I’ll be mulling over so I can give the investment team a definitive answer in the very near future.

Hedges Are Making a Difference

There’s no point in sugarcoating it – the market has taken a pretty good beating over the past couple of weeks. The S&P 500 is off by about -7% since its most recent high on July 7th, and yesterday was just plain ugly as the selling intensity picked up throughout the day and ended with a -2.5% loss.

Today, stocks opened with even more selling – dipping all the way down to 1234 and in the process blowing right through what seemed like pretty good technical support at both the March and June lows around 1250 on the S&P. But, stocks staged an impressive turnaround and actually managed to close higher on the day, so perhaps a bounce is finally developing after 8 straight days of selling.

With investor angst reaching feverish-pitch levels on the heels of the debt ceiling drama and the latest market decline, there is actually some good news in all of this. Many of the portfolio hedges that we currently own for exactly this type of volatility are working as expected – gold continues to make a new record high almost daily, and Treasury bonds have rallied like crazy the past several days.

So, we’ve been able to dampen the blow from the equity markets somewhat. But we’re not just remaining complacent, either. Recent economic data and market action has been increasingly poor, and if this continues for much longer, we may need to take additional defensive measures in portfolios.

Chart: S&P 500 (black), 20+ Year Treasury ETF (brown), Gold ETF (blue)

Risks Inherent in Risk Protection

Given the amount of macro risk currently facing markets, we have a number of hedges employed in our portfolios for different scenarios. If you’re a fan of the deflation argument, we own some long maturity Treasury bonds. If you’re more worried about inflation or monetary debasement, we own some gold. If the risk of further deterioration in the euro-zone and common currency is what keeps you up at night, we own a U.S. dollar index fund. If you’re skeptical about all of those scenarios, we’ve also simply increased cash weightings, willing to temporarily accept 0% yields as a trade-off for principal stability. These hedges all contribute to portfolio protection in certain scenarios, but they also have their drawbacks as they are volatile and carry their own risks.

Long maturity bonds are at risk to a reacceleration in the economy, and the debt ceiling not being raised in time. Gold is at risk to less global liquidity, a higher dollar, and a rise in real interest rates. The dollar is at risk to a continuing downtrend in real interest rates, debt ceiling dynamics, and plain old relative underperformance in U.S. real growth rates vs. other economies. Even money markets take on some risk in the form of embedded European debt exposure and uncertainty regarding the possibility of a U.S. credit rating downgrade.

Given that every hedge has its own risk, what’s an investor to do? If you want to insulate your dollars with 100% certainty, I suggest stuffing some cash in your mattress. Of course that only works if you can live with the risk that your house may catch on fire, you get robbed, etc., etc., etc…

Transparent Portfolios and Hedge Transactions

Last week we put on a hedge transaction in our managed accounts by buying an Exchange-Traded Note (ETN) designed to track the VIX volatility index. Like many institutional money managers, we have been cautiously participating in a bull market characterized by enormous liquidity-driven momentum. As the price of the stock market continues to float well above both its short-term and long-term trend lines, each dip in price raises the specter that the market will finally take a well deserved breather, having rallied by close to 70% in the 8 months since the lows set in March of this year. Last week, for the first time in months, the market closed below its 50-day moving average and we thought it was prudent to manage the risk that the market might continue to correct down to its 200-day moving average, a normal event for a correction in a bull market, but would result in a further 11% or greater market decline.

By choosing the VIX (Chicago Board of Options Exchange Volatility Index) as our hedge we were betting that if the market sold off, then volatility would dramatically increase from very depressed levels. Having watched the index jump by about 15% as the market fell to its 50-day moving average, we were betting that it could move an additional 30% or more if the correction continued. Unfortunately, we stopped out of this trade with a 12% loss as the market turned on a dime and headed higher again. Our 4% position lost 12% resulting in a “cost” for putting on the hedge of approximately 0.48%, plus transaction costs, plus the cost of whatever interest we lost from selling cash and bonds to put on the trade (which were minimal in our estimation). We view this “cost” as a very acceptable price to pay for managing the risk that the market is due for a significant correction, even if it didn’t turn out to occur last week. In our view, it certainly was better than selling our current risk positions in an attempt to time a short-term market decline. Buying and selling the VIX was an easy transaction to put on and take off, and while the results didn’t work out, I view the risk and reward of this transaction as not only acceptable, but necessary in volatile markets like these.

In my book, Buy and Hold is Dead (AGAIN), The Case for Active Management in Dangerous Markets, I write that one of the challenges that active portfolio managers must meet is transparent portfolios. By transparent, I mean managed accounts where clients can see the transactions in their portfolio, in contrast to investing in say a hedge fund or a mutual fund where the client does not see the transactions in the fund. The reason that transparency represents a challenge to active managers is that each client can view portfolio transactions through the lens of whatever their personal investment biases happen to be. In this case our hedge position has resulted in a very short-term transaction that resulted in a loss. We will have certain clients reasonably asking for an explanation for this trade…..concerned that the transaction lost so much in so little time. And we will have some of our wealth managers asking the same questions…since they have to explain this to our clients (SIGH). I don’t think anyone will be thrilled when we do a similar transaction the next time the market rolls over so far above its long-term trend line.

Well…That Was Easy

The Pinnacle investment team has been patiently waiting for a serious correction in the recent torrid bull market for months. To us, a correction in a bull market means something like a 10% - 15% decline – enough for us to feel good about buying a dip in an upwardly trending market. Unfortunately, the market has not given investors the opportunity to jump in and buy a dip for months, with the closest thing to a correction being a 7% decline that occurred from June 12 to July 10 earlier this year. But now, for the first time since July, the tone of the market seems to be changing with the market once again declining 6% from its high of 1097 on October 19th. We are going to implement a hedge position as a trade to take advantage of a possible nasty short-term correction. It seems like it aught to be easy enough to do, but…

• Should we hedge by buying a 2X position in the U.S. dollar assuming the dollar will rally on a market decline, or buy a 2X inverse S&P 500 Index fund that should earn two times the decline in the market, or buy the VIX volatility index (Chicago Board of Options Exchange volatility index)?

• If we choose the VIX, can we be comfortable with the tracking error between the exchange traded note for the VIX Index (ETN available through iPath called VXX) and the actual underlying VIX index?

• If we put on the hedge, where do we get the cash to execute the trade? We have some cash in our managed portfolios for the buy, but what else needs to be sold to take a 4-5% position in the hedge?

• We first looked at this transaction last week and since that time the VIX has had a big move to the upside. Is it too late to buy it now that it moved more than 10% higher last week?

• We executed a complicated transaction in our fixed income allocations last week and now we can’t execute the hedge trade until the prior week transactions settle. Will the market allow us to still get in while we wait the extra days for the prior trades to settle?

• One of our analysts feels like we have seen the ultimate top to this cyclical bull market that began in March of this year and so he likes the hedge trade. Another analyst is worried that we won’t get much more on this correction and doesn’t like the trade. Another analyst thinks the trade works as is.

For Pinnacle’s investment team, the details of this transaction are just business as usual.