Statistically speaking a 10 to 20 per cent correction should occur about once a year (averaged out over time). Hence to see one shouldn’t be such a great surprise...but when it occurs, how do we handle it?
Back to first principles
An inevitable part of investing in markets is that sometimes, prices go down. Yet there is something to be noted in terms of scale here. When a recession occurs, the market's downside is usually about 30 to 50 per cent. With no recession, the downside is more 10 to 20 per cent.
As far, we have no recession and relative to history, the market (in my view) appears to be acting in accordance with the behaviour we’ve seen during other temporary corrections which go onto be extensions of the bull market.
Could we hedge out such a correction? Well, we may not necessarily want to do this (I’ve discussed how to hedge on my previous Livewire blogs). If we were to hedge it out completely, we’d end up with a portfolio which is riskless and thus should only earn the risk-free rate of return over time…which is kind of pointless.
(It could be argued that the return of a hedged portfolio is the risk-free rate PLUS the alpha of whatever investment strategy is being run..but usually the hedge costs you a good chunk of this alpha so I’m happy to leave that out.)
So what could investors do?
I would argue that we don’t want to completely hedge, we should allow for some downside variance in our portfolio as long as we don’t let it get out of hand. We can even also use volatile stock prices to buy up hedges as they become cheap and sell them off as they get expensive. So by doing this and being not fully hedged, we take some portfolio losses but still get a step ahead of the market through hedging profits.
If our view that the correction is temporary becomes reality, then our losing long positions will eventually become winners whilst we’re still holding onto our locked in hedged profits.
What if we’re wrong?
What if we are about to go into a recession?
Firstly note that the S&P500 being down 13 per cent or so in itself is not an indicator of a future recession. The news always makes it seem like it’s coming tomorrow but they are really just reacting to the last price move. Recessions occur when the ‘debt cycle’ blows up, so we should start by looking there.
And if we do look there, we can see a lot of risks! Readers may have heard me talk about how I’ve run through the prospectus’ of large corporate bond portfolios and found them loaded with debt whose ratings are (in my view) shaky.
We know that many companies have received financing whilst interest rates were low that shouldn’t have (zombie firms) and it’s questionable how much debt out there will become impaired once rates normalise.
And of course, debt drives consumption in the short/medium term. Global consumption is global production and so if debt can't be rolled over/issued and companies become bankrupt, consumption must go down, production must go down, global GDP must go down and thus a recession is created.
But we need to wait for some hard data which shows that the debt cycle is going backwards and that simply a whiff of good news won’t counter the negative signs.
At The Vega Fund, we don’t invest in stocks but use options to invest in the markets. When we make an investment with options to go short, it’s expensive and risky. Hence we only want to do so when we’re highly confident that it will pay off handsomely.
To sum it up
The Vega Fund is a data-driven quantitative fund. It’s currently close to going short and if economic data comes out weak over January/February, that’s the direction it will likely be taking.