Are We Heading For A Stock Market Crash?

This article was first published on 30th July 2017 as our July edition of our monthly newsletter; Asia-In-Focus Report. To get our latest newsletters, sign up for free here.

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Asia-In-Focus

June 2017 Edition

Are We Heading For A Stock Market Crash?

“…be fearful when others are greedy and greedy only when others are fearful” Warren Buffett

I have been having this unsettling feeling for quite a while now. I have been having this feeling that the stock market might be heading towards an unavoidable crash in the near future. I know that I am just speculating and I know that we should not be using our emotion when investing. Yet, I am still getting this uneasy feeling over and over again in the past few months. Why?

For one, my personal portfolio has been seeing record gains month after month. The last I counted, almost 90% of all my stocks are giving me positive return this year, some more than doubled within the last six months. Everyone loves seeing their portfolio grow but having 90% of them all growing together at breakneck speed is not fun at all. Because I know I am not that smart to be able to pick winners so accurately. Something must be going on.

Then there was that little issue with the VIX. The VIX Index, is the Chicago Board Options Exchange Volatility Index. It is an Index showing the market’s expectation of the 30-day volatility. It is basically constructed and computed based on a number of S&P 500 index call and put options. It is a way for investors to gauge how volatile the market will be in the short term.

Volatility is the magnitude of price swings happening in the market. For example, the VIX was high during the period like the 2008 Global Financial Crisis when the stock market crash, with prices dropping by a huge magnitude everyday. The VIX Index is also commonly referred to as the “Fear Index” of the market. It generally spikes when the market is fearful. Yet, over the past two months, the VIX Index has been at its lowest level since the Global Financial Crisis; indicating that investors now might be feeling the opposite of fearful. They might be edging towards “greediness”.

One more thing that pushed me from being a passive worrier to an active seeker for a solution is the memo of Howard Marks, the Chairman of Oaktree Capital, one of the largest hedge funds in the world. Howard Marks has been a great investor that I have great respect for. In fact, his book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor, has been one of my favourite investment books of all time.

In his latest memo, Howard Marks sounded off some warning signs that the general market is getting more greedy and starting to disregard the risk in the market. He talked about how bargains are much harder to find now in the market (A view that I agreed), the S&P 500 is trading around 25 times its earnings compared to its long-term median of just 15 times and that the VIX Index is at all-time low.

I got even more unsettled about my unsettling feeling after reading through his memo. However, I was struck in a conundrum and need to find a way around it. The problem is basically:

• We can never time the market. So even if we know the market is quite high, that doesn’t mean the market will correct soon. The crash might come in the next 2 years or the next 2 months or tomorrow.
• I am still quite optimistic about the long-term prospect of the companies I invested in. If I sell them off today just because I felt the market was overvalued, I might miss out on the chance to reinvest back into them in the future.

So for the past week, I have started searching for a way to buy some “insurance”. By “insurance” I am referring to what the financial industry deemed as hedging. To find a way to minimize the losses in my portfolio if my expected event, (a crash), really happen. Here are a few ways I found. Most of the options I found were not the perfect solution so I have yet to decide which method I would use to hedge my portfolio. Maybe you can take a look at the options and let me know what you think.

Option 1: Short The S&P 500

Since we are expecting a market correction, a direct way might be to just short the S&P 500. You can either really go out and short some of the more common S&P 500 ETF. A short is basically borrowing stocks from your brokers and selling them in hope to buy them back at a cheaper price. Shorting will involve some additional cost from your brokerage firm. Some of the common S&P 500 ETFs are the SPDR S&P 500 ETF (SPY), iShares Core S&P 500 ETF(IVV) and the Vanguard S&P 500 ETF (VOO). But in effect, I would be betting against the largest and some of the best 500 companies listed in the US market. It does not sound that wise when I put it in that context.

Option 2: Buy Inverse S&P500 ETF

Another option for me is to just buy inverse S&P500 ETF. So, rather than shorting the S&P 500 ETF myself, these ETFs would short the index for me. The more common inverse S&P 500 ETF are Proshares Short S&P500 ETF(SH), ProShares UltraShort S&P 500 ETF (SDS), ProShares UltraPro Short S&P500 ETF (SPXU) and Direxion Daily S&P 500 Bear 3X Shares (SPXS). Some of these ETFs even provide additional leverage by tracking 2x or 3x the returns of the S&P500 index. Reading the prospectus on these instruments are quite tedious for me.

Option 3: Long The VIX Index

We cannot technically buy the VIX Index there is no underlying entity to it, unlike the S&P500 Index. However, there are still ways of try to mimic the return of the VIX Index. There are some Exchange Traded Note (ETN) such as Barclay’s VXX or VXZ that would try to mimic the return by buying VIX futures. However, the problem with futures is that they have time value. That means the longer the time to their expiry, the more expensive they tend to be. In other words, their value will decay as time passes. That is a terrible problem to have because time never stops. In some instances, the time decay can be as much as 4% per month, or 48% a year.
In effect, I would be taking a loan at 48% a year in hope that the stock market will drop. This does not sound appealing to me.

Option 4: Buying Put Options On S&P 500 Index

Another way to buy insurance on the market is really just buying insurance. This insurance comes in a form of Put Options. A Put Option is an option to sell a certain underlying asset based on a predetermined price. Basically, if I buy a Put Option on the SPDR S&P500 ETF at a strike price equal to the current market price, I have bought the option to sell this ETF at this strike price even if it has declined in value in the near future.
This is in fact what billionaire investor, George Soros, is doing. It was revealed that George Soros has purchased some Put Options on a few market indices ETF earlier this year. But like futures, options have time value as well, meaning that it is an indirect interest cost to buying that.

Option 5: Sell All My Shares

I really don’t like this option. My portfolio was built up over the past decade, there are companies I have owned since the very beginning. I am just not sure if I would be able to reconstruct the portfolio back to my liking in the future if I liquidated them now. Plus, I don’t think the situation is that urgent for such a drastic move.

More Complexity
To add to the complication, most local brokerages might not have access to some of these instruments, meaning that my options could be even more restricted.
So there you have it. This is just a framework I use regularly to manage my portfolio. I would find out:

1. What is my concerns at the moment about my portfolio?
2. What is the objective I want to achieve?
3. What are my options?
4. Make a decision.

Investing is not so much about picking the right stocks that would give you a good return. Long-term success in investing is about forming a good framework for analysis and a structured process which stock to look at, what to look at, how to look at them and making buying and selling decisions.
I have not decided which option I would use to hedge my portfolio.
Just for fun: What about you? What will you choose if you are me? 
Click here to choose.
Till we meet again.
Regards

Stanley Lim
Editor

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