Tuesday, February 18, 2014

"The easiest way for your children to learn about money is for you not to have any." --Katharine Whitehorn

HDGE IS AN IDEAL WAY TO FADE THE POPULARITY OF GENERAL U.S. EQUITIES (February 18, 2014): General U.S. equity funds have been highly popular with investors since the beginning of 2013. They briefly went out of favor near the beginning of February 2014, but as the S&P 500 Index has approached its all-time peak, most investors are convinced that they are going to remain in the market "for the long run" even though they didn't even bother to participate during 2009-2012 because of negative emotional memories of the 2007-2009 bear market. As a result, it is highly untrendy to consider selling short or to otherwise wager that U.S. equities are likely to be substantially lower in 2016. Since the mid-1990s, the S&P 500 Index has formed a pattern of numerous higher highs and lower lows, which is known as a megaphone formation. The 1997 top was exceeded in 2000, which was surpassed again in 2007, and which has led to a new all-time high in recent weeks. Similarly, the 1998 bottom was followed by a lower low in 2002, a deeper nadir in 2009, and what will eventually become an even more depressed reading in two or three years. Each time that we achieve one extreme or another, investors conclude that prices will either keep climbing or keep declining indefinitely, forgetting that the financial markets have always been cyclical. It would be as though a very cold spell each January convinces people that we won't have summer the following July [you can reverse these months if you live south of the equator].

There are many ways to benefit from a slumping stock market, but perhaps the best one is by purchasing an actively managed fund of short U.S. equity positions with the symbol HDGE. By owning this fund, you won't be forced by your broker to repurchase your shares because your broker can no longer borrow them. In addition, if you sell short directly, then you will achieve a short-term capital gain taxed as high as 43.4% even if you hold your short position for more than one year. However, if you buy HDGE, then if you hold it for at least one year and one day it will qualify as a U.S. federal long-term capital gain which has a top tax rate of 23.8%. If you are in a low tax bracket, then the differential is 15% short-term versus 0% long-term. If you prefer shorter-term trading, which is ideal for a retirement account, then you can buy HDGE whenever VIX is depressed, with the idea of selling it whenever VIX has recently surged to a short-term peak and begins to retreat.

Speaking of VIX, almost no one has noticed that VIX has formed a pattern of higher lows since it bottomed at 11.05 on March 14, 2013. For nearly one year, VIX has been forming a pattern of several higher intraday lows. The last time that VIX bottomed at a multi-year nadir was on December 15, 2006 at 9.39; we know what happened afterward. It's not different this time. VIX measures the implied volatility of a basket of options on the S&P 500 Index; a slow rise in VIX over the course of one or two years indicates that the most knowledgeable options traders are progressively charging more to insure equity portfolios. The media sometimes discuss VIX, but they don't know how to interpret it properly. Similarly, an extended pattern of lower highs for VIX, such as we experienced from October 2008 through March 2009, indicates that a strong U.S. equity bull market is approaching.

There are other "bear funds", but none of them actually sells short equities directly and exclusively. Nearly all of them speculate in the futures market, and therefore will erode in value. If the underlying security is unchanged, you will end up losing money. In addition, the two managers of HDGE have excellent track records of selecting equities which will decline more than the overall equity market during any bearish downtrend. Even though this fund has existed for only a few years, its track record already proves the co-managers' ability to make enlightened bear-market choices. The management fee is somewhat high, but it is justified by the capital-gains qualification, the frequent portfolio adjustments, and above all the past performance during stock-market pullbacks.

Disclosure: In late August and early September 2013 I was aggressively buying the shares of emerging-market country funds. Since early December 2013, I have added moderately to my funds of the most undervalued mining shares and emerging-market equities, especially during their most extended pullbacks. Most recently, I have been buying HDGE whenever it has traded below 13 dollars per share with the idea of selling it in 2016 as we are completing the next U.S. equity bear-market bottoming pattern; HDGE is an actively managed fund which sells short various U.S. equities. From my largest to my smallest position, I currently own GDXJ, KOL, XME, GDX, SIL, COPX, REMX, SCIF, EWZ, GLDX, IDX, VGPMX, RSX, GXG, ECH, HDGE, BGEIX, VNM, URA, ZJG (Toronto), PLTM, EPU, TUR, SLX, SOIL, EPHE, and THD. I have significantly reduced my total cash position since June 2013 in order to increase my holdings of the above assets, and currently hold about 20% of my total net worth in cash and its equivalents. I sold almost 90% of my SLX near 49 dollars per share because steel insiders were doing likewise. I plan to buy more HDGE each time it suffers a short-term pullback, because I expect the S&P 500 to eventually lose more than half of its current value--with most of that loss occurring during 2015-2016.