How To Be Defensive In A Bull Market

August 26, 2014

Be skeptical, not pessimistic, and use hedges.

Jared Dillian is the editor and publisher of  The Daily Dirtnap, a market newsletter for investment professionals, and the author of  “Street Freak: Money and Madness at Lehman Brothers.”

I was writing the other day in my newsletter, The Daily Dirtnap, about the $1 trillion (that’s with a “t”) in corporate bond issuance so far this year, and how a lot of it has gone to buybacks, and how it’s hard work being short a stock that is buying back stock.

In fact, it’s kind of senseless to be short the market when many of the companies in the S&P 500 are buying back stock.

Companies are taking bondholder-unfriendly actions with all these bonds they’re issuing, leveraging up balance sheets big time. As long as the credit markets are accommodative, this will probably continue indefinitely.

It’s hard to imagine credit repricing unless the default rate picks up, and it’s hard to imagine that happening unless we have a genuine recession. And all that’s really hard to imagine happening because the Fed won’t allow it. So we’re caught in this do-loop where the market goes up every day except for days that don’t end in “y.”

How To Size Up The Market

As an investor, what are you supposed to do? Bull market? Long and strong? There are a lot of reasons not to do that. Stocks are not in a bubble, but they’re definitely not cheap. Certain sectors, like tech, are just goofy.

There is a food fight (get it?) in restaurant IPOs. There are a lot of warnings signs. But bull markets can continue for years when warnings signs are clear and copious. Naturally, the way you would want to play it is to retain exposure to the upside while limiting losses (which, by the way, is the holy grail of investing).

This can be achieved through broad-based index puts against a long portfolio. If you have the analytical tools, you can drop your portfolio into the portfolio analyzer-thing and it will tell you what index your basket most closely resembles. Or you can get cute and buy puts on the index that is most overvalued (like the Russell 2000).

But the thing about puts is that even when they’re cheap, they’re expensive, and even when they work as insurance, you have to trade out of them at the right time or the whole exercise is pointless.

 

 

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