Shorting the Market – What does that mean and why do it?
After living through the largest one-week sell off in recent memory for the stock market, we felt it would be helpful to shed some light on things for you, our clients. We’ll discuss a few topics:
Some reasons for the sell-off.
Is it rational?
How does this compare to other market corrections, particularly in recent years?
Is this different from a sell-off during the trade war?
Can the Fed come to the rescue?
Methods for protecting a portfolio of investments.
As we discussed in our previous blog The Current Wall of Worry the market has had an incredible run up since the beginning of the 4th quarter of 2019. You can read that blog to see some possible reasons for the run up. So, what happened? Why has the market erased nearly all those gains in the span of one week? There are some ideas floating around that it has to do with different candidates in the presidential election, while there could be some merit to those arguments, we believe the Coronavirus (COVID-19) to be the primary reason for a repricing of equities.
Why does it have such an impact on
the stock market and is it rational?
Let’s take a step back and consider a couple of things. When buying a stock, an investor is buying a piece of a company with the expectation of sharing in the profits of that company, through growth in the stock price and in many cases, through the payment of dividends to the shareholders. The stock market is an auction with buyers and sellers and the price of a stock moves relative to the supply and demand – when there are more buyers than sellers, the price tends to move up and vice versa. Investors tend to look roughly two years into the future when trying to decide whether a stock is cheap or expensive relative to its outlook. In our previous posting we highlighted many of the positives in relation to the US economy. These positives boded well for the 2-year outlook of many companies.
Keeping all of that in mind, what happens when the outlook changes? There is a repricing of companies perceived value – this is reflected in the stock price (market value). So, is the sell-off we’ve seen rock the markets this past week a rational response?
Let’s think through the impact the Coronavirus could have on all the positives in the economy. What is huge driver of the US economy in particular? Consumption. What happens if the supply chain for goods and services gets disrupted and goods can’t be delivered at the expected rates? Less consumption. What happens when the stock market gets slammed and consumers are fearful of losing money? Less consumption. Let’s consider some others:
Closure of factories, disrupts supply chains
Workers having to stay home due to closing of factories, less disposable income
People afraid to go into group settings and risk exposure to the virus
Uncertainty, uncertainty, uncertainty – the list goes on.
You probably get the point, there really isn’t any economic upside. Not to mention the loss of life and potential loss of life.
All these factors weigh on the outlook and there isn’t a definitive end in sight right now which is why there’s so much uncertainty. We circle back to our most popular line – Uncertainty is the enemy of the market.
What’s different from this correction compared
to others in the last couple of years?
There isn’t a finish line yet or a big picture end goal. You can go back through our market updates of recent years to read our thoughts on the rationale behind many of the market moves (Interest rates, trade war, inflation, employment, vix reactions, algorithms, etc.)
With the China trade war, investors could lean on the assumption that the president had an end game, so sell-offs would be temporary in nature and would be reactionary to a twitter feed, rather than fundamental factors. With the Fed rate hike cycle in 2018, rates were going up because of many positives in the economy. So, investors could see the light through the headline. We don’t see any upside to the virus, which is why we began taking a defensive approach to our portfolio at the end of January.
Can the Federal Reserve come to the rescue?
With the trade war, a cut in interest rates could alleviate some of the pain. However, we don’t see the same impact in this situation. If a factory gets shut down because workers are getting sick, we don’t think it matters if that business can borrow money at a lower rate. We may see a bump in stock prices if the Fed announces it will lend support via a rate cut, however, we don’t see this as solving the problem.
How should an investor respond to a situation like this?
In general, there are two camps when is comes to investing. Passive investors and active investors. The theory behind passive investment is that you should build a well-diversified portfolio based on risk tolerance and then not touch it apart from some rebalancing of asset class weightings. This means riding out the waves and hopefully you’re diversified in a way that doesn’t sacrifice upside return while also reducing downside risk. Active investors on the contrary, believe there is a benefit to paying attention to what’s going on in the market and try to take advantage of what they see and believe to be coming based and rules and analysis of many variables, both technical and fundamental. Again, how should an investor react? In the day and week, we just lived through, a passive investor should tighten their seat belt and hang on. An active investor should be following their rules, considering the big picture, and protecting their portfolio where prudent.
How can an investor protect their portfolio?
There are lots of choices when it comes to portfolio protection or “safety” plays:
Use of the options market
There are many ways to build a portfolio that provides protection against downside risk. We’ll dig deeper into one method here – shorting the market. The explanation of how shorting works is actually very complicated, but the result is very simple. A short position loses value when the underlying asset increases in value and gains value when the underlying asset decreases in value. For example, if you were to short the S&P 500 in a 1 to 1 ratio. If the S&P 500 falls 5% that short position should increase by 5%. This type of position provides a hedge against the downside when it is incorporated into a portfolio.
So why doesn’t everyone short the market to some degree? Most prudent investors do use some form of protection (most commonly incorporating bonds into their portfolio) to some degree. But the risk is a watering down of upside returns. That’s why every investor needs to determine what level of risk they can stomach and then build a portfolio around that tolerance. Although a short position can provide downside protection, like all types of insurance, it comes at a cost. The cost of a short position is that it will lose value when the underlying asset increases in value. So, you must be nimble when it comes to shorting something.
If you’re reading this post as a client, we would love to explain further how we’ve incorporated different levels of protection into your portfolio throughout the past several weeks. If you’re reading this as an investor, or someone who’s considering the benefits and risks of investing, we’d love to tell you about our approach to things. You can schedule a time here.
With all things that provide great reward, there are often significant risks. We sincerely appreciate the trust our clients have placed in us to help them navigate both factors. It is a joy to be a part of your financial lives.
Authored by: Michael McCracken CFP®, ChFC and Jeffrey Gardner, Financial Advisor The information presented above has been prepared for informational purposes only and the commentary represent the opinions of the author and are subject to change at any time due to market or economic conditions or other factors.