Bulls Make Money, Bears Make Money, (Un)Hedged Hogs Get Slaughtered

We’ve talked quite a bit about what companies and sectors are most vulnerable to Brexit and a rising dollar (see here and here). Let’s look, for a moment, at asset classes and equity drawdowns.

Over the past several days, the need to hedge against long tail events has become readily apparent. Unfortunately, hedging against macro event risk is notoriously difficult. Need proof? Just look at how your favorite “rockstar” hedge fund manager performed last year. Or ask Ray Dalio how risk parity worked out during the late August rout. Or just look at the table below which shows YTD returns by strategy:

(Table: BofAML)

Compounding the problem for investors is the fact that thanks to eight years of ultra accommodative monetary policy, bonds aren’t necessarily an attractive way to guard against collapsing equity prices.

Take Europe for instance. You might have been tempted to buy yourself some safe bonds in the days and weeks ahead of the UK referendum - that is until you found out that €3 trillion (that’s trillion with a “t”) in EUR-denominated bonds trade with negative yields. Believe it or not, €64 billion of that is corporate credit! That is, you’re actually paying companies for the privilege of loaning them money.

The point is, if you’re buying high quality debt, you may be buying right into a blow off top. In fact, if you look at two-year-and-in government paper in Europe and Japan, nearly 100% of it has a negative yield-to-maturity, which explains why Treasurys look “attractive”...

(Charts: Deutsche Bank, BofAML)

...even way down here at 146:

So where’s a guy (or gal) to turn in order to protect against an equity drawdown?

Well, you could buy some puts for starters, but let’s look at asset classes besides bonds, as fixed income is simply too rich right now.

We’ll start with gold. Goldman raised their target for the yellow metal this week and it’s understandably been bid in the wake of the Brexit vote. So how effective is it as a hedge? Here’s Goldman with a bit of color:

“The correlation of the S&P 500 with gold has been close to zero on average since the 1990s and outside of the late 1980s and 1990s drawdowns and gold provided a hedge in large equity drawdowns.

“The gold rally into and post the GFC has been alongside a steady decline of real yields (Exhibit 24) and going forward higher US real yields might weigh on gold prices in US$. However, gold should be able to provide a hedge in currencies where real yields are anchored and there is less reflation momentum such as Europe and Japan.”

(Charts: Goldman)

Ok, got it. What about commodities? No. Don’t even think about it (at least in terms of finding a reliable hedge). Here’s why:

That’s a simple regression using YTD data and what it shows is that oil and the S&P are highly correlated this year. So there’s no diversification to be had there.

So bonds, no. Gold, maybe depending on how it’s denominated. Oil, definitely no. Of course there’s always cash.

Next, let’s take a look at a great table from Goldman which assumes a baseline portfolio of 60/40 stocks and bonds and then shows what happens to returns and volatility during a 20% drawdown:

(Table Goldman)

Here’s some color:

“Following a period of high risk-adjusted returns in the last decade, the risk of larger drawdowns for 60/40 portfolios has increased, in our view. There have been real total return drawdowns for a 60/40 portfolio in excess of 20% since the 1950s (Exhibit 29). The majority of ‘safe’ assets have some incremental diversification benefits for a standard 60/40 portfolio over time, but with varying consistency. And with most traditional asset classes expensive and vulnerable to specific shocks, investors need to diversify for multiple risks (growth and rate shocks, commodity shocks, financial market shocks, China) and position for different macro scenarios (secular stagnation, stagflation, reflation).”

Right. So that’s not very helpful. But the table is. Note that the return/vol tradeoff makes a pretty good case for cash, as painful as that is to come to terms with.

Let’s close, for now, with one last graphic. This one shows which sectors perform best coming out of a pullback assuming you want to stay in equities:

(Graphic: Credit Suisse)

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