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How To Ride A Bucking Bull: Stay Calm And Hang On…For Now

Take measured risk: If the exposure or leverage to the market is too large (greed), then the pullbacks have the potential of taking us out of the market (i.e. fear). If the risk is too small, then the returns are not large enough. A good rule of thumb is to scale the risk large enough where being wrong does not create permanent capital loss.  When it is impossible to time turning points, and staying invested is the only alternative, then it follows that permanent loss management is the key ingredient for staying on the bull.

A numerical example might help. Suppose we expect the equity market to deliver an annualized volatility (standard deviation of returns) of fifteen percent. Then any given day we expect the volatility to be roughly one percent.  For a portfolio that has half of its risk budget invested in equities, we can then expect a daily volatility of about half a percent coming from equities. At least once a month one should expect the portfolio to make or lose roughly a percent or more (or two standard deviations). In raw dollars and cents, suppose one has $100,000 to invest.  This means a daily volatility of about $1000 if fully invested in stocks.  So once every few days, one should expect to lose over $2000.  So scale the exposures to be able to stomach this risk. That’s what it takes to ride the bull.  Else, better to watch the rodeo from the stands.

Use all tools available: The trick, in bull-markets, as in bull-riding, is to “ride the buck, not the bull”. Or, anticipate what might happen next and position for it.  What this means in practical terms is to use all the markets and the alternatives available. What goes up will eventually come down, so being long the market via strategies that don’t lose too much is one way to stay on the bull.

One example, which is further discussed in detail in a recent Journal of Portfolio Management article I wrote titled “Right Tail Hedging: How to Manage Risks When Markets Melt Up,” is to use cheap, liquid call options on market indices to obtain long exposure with a finite maximum loss potential. When markets, like bucking bulls, can jump up, call options can provide an exposure to the un-priced up jumps efficiently.

The reason such call options are cheap arises from the excess supply of these call options, from yield enhancing strategies such as volatility selling and covered call writing. Call options can allow investors to hang on to positions rather than reacting to the latest tweet. Of course, this optionality, like everything else in the market, is not free, and the price is not always very low. Also, if the markets don’t jump enough, then the investor loses all the premium paid for the call options. So a cost-benefit tradeoff of the value added obviously needs to be performed before delving into options. Today they happen to be cheap given the true risks of market “melt-ups.” Just as an example: for the SPY ETF a call option struck at the money, to year end 2018 costs about 2.25%. This means that the S&P 500 has to finish above roughly 2975 for the option to go in the money.  No guarantee that it will, but for someone riding the bull into year end this price could be cheap enough to take the risk of getting bucked off the table.  Of course one can just keep the exposure to equities as is, and buy put options for protection as well, but that requires monitoring two different things.

Plan now for the dismount: Finally, it is important to not get “married” to the bull. In bull-riding, once the eight seconds are up, there is no glory in staying on the bull. Likewise, when the bull market extends euphorically, as it is did earlier this year, it is time to start planning the dismount. There will be other bulls to ride.  If nothing else, one should have an “exit strategy” in mind before mounting the bull.

A great example of a bull that has been ridden for almost three decades now is the bull market in developed market bonds.  As we speak, this bond market is starting a multi-year correction.  Market participants have ridden this bull, and many now realize it is time to get off.  The Central Banks of the world are getting off the bond bull. With QE ending, rates rising, and wage inflation picking up, one doesn’t want to be the last one holding expensive long term government bonds.  And when developed market yields are rising, proxies for yield such as junk bonds and even emerging market assets (equities, bonds and currencies), are competing for investment dollars.  There may be more room for emerging assets to fall before they will be as enticing as say, low risk Treasury notes with a guaranteed principal.  And yes, the equity bull market will also eventually end, and it won’t be pretty if there is a mass exodus. For the immediate here and now, the fear might be worse than the reality.

Having been in the financial market rodeo for almost three decades, a lot of what I read many years ago makes sense: You have to be in the game to win the game, which, in bull markets means to take just enough risk not to be knocked out too early.  Fortunately the market has plenty of tools to implement simple risk management strategies to keep you invested with the right amount of exposure.  This bull market will continue to buck, so hanging on won’t be easy.  If one doesn’t get bucked off the bull, there might be a chance to outlast the wildness.



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