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With the recent rise of the market, and the statement from Hamblin-Watsa that they are continuously monitoring the market for hedge purposes, I was asking myself to what level of the S&P500 I should hedge my portfolio.

 

S&P500 reached a high plateau of about 1500 in 2007. If you buy the future scenario like the one Billl Gross is elaboring (i.e. future growth will be much lower in the years to come) and if you think that the earnings in the 2006-2007 era were inflated by leverage in the banking and real estate sectors, then you should not expect S&P500 to reach 1500 anytime soon on a fundamental basis, because this equates to lower E and lower P/E. This is so subjective, but if in the short term the S&P500 would reach 1200, then I would be tempted to say that the market is priced for perfection, i.e. V shaped recovery.

 

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FT,

 

Why speculate on a hedge?  What special insights do you have into the future of the S&P 500 that make it worth allocating your hard-earned money?  Here's a reasoned counter-argument...

http://online.wsj.com/article/SB10001424052970204518504574420811475582956.html#articleTabs=article

 

Maybe an S&P bet is not such a "fat pitch".  H-W made its hedges when there was substantial evidence of massive credit issues and Watsa presented his arguments to shareholders at the annual meetings in 2006 and 2007.  Further, if inflation starts, E inflates and why cap your P?  If economy recovers, E inflates and why cap your P?

 

-O

 

With the recent rise of the market, and the statement from Hamblin-Watsa that they are continuously monitoring the market for hedge purposes, I was asking myself to what level of the S&P500 I should hedge my portfolio.

 

S&P500 reached a high plateau of about 1500 in 2007. If you buy the future scenario like the one Billl Gross is elaboring (i.e. future growth will be much lower in the years to come) and if you think that the earnings in the 2006-2007 era were inflated by leverage in the banking and real estate sectors, then you should not expect S&P500 to reach 1500 anytime soon on a fundamental basis, because this equates to lower E and lower P/E. This is so subjective, but if in the short term the S&P500 would reach 1200, then I would be tempted to say that the market is priced for perfection, i.e. V shaped recovery.

 

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Well I'm not saying i would hedge at 1200 (i.e. 15X 2006 all time record earnings for the s&p500 ) but to me it looks like a fair if not generous value of the S&P500 post recession.

 

If the market rise too fast, and priced for perfection, I would considered that the potential of it rising further is limited and the risk of falling is higher. At a certain point it would make sense to hedge.

 

Of course many things can happened.

ex:

-Second stimulus plan, continuous deficits...  which would deferred liabilities'payment for the excesses of the last bull market.

-USD devaluation which would boost international compagnies'profits included in the s&p500

-etc

 

 

 

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fair if not generous value of the S&P500 post recession.

 

Simple, non-trick, question for all those on the board and you finetrader:

 

Did the recession change the S&P fair value in a meaningful way?  If so, by how much... and why?

 

I won't posion the discussion with my answer, but I'm very curious what others think.

 

thanks,

 

Ben

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Well Ben,

 

Use long term p/b ratios or some kind of asset based equivalent. 

 

I would say we are about 20% below average for the S&P 500 (1200 to 1300 would be the average).  It needs to be determined on asset values.  Asset values have dropped temporarily but not significantly since they are primarily made up of Property Plant and Equipment.  Therefore the Book Value is not too impaired - maybe 10% maximum across the S&P 500 Universe. while the price side of the equation is way down. 

 

Long term Price to Book Ratio for the S&P 500 (Ned Davis Research is 2.4).  The chart I located only goes to October 17 2008 which is almost exactly where we are now.  So another 30% upside to AVERAGE!

 

http://4.bp.blogspot.com/_m3CQF7whYY4/SQI-Ko558zI/AAAAAAAAA68/2XRczpkUVeA/s1600-h/spy.JPG

 

 

 

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Well Ben,

 

Use long term p/b ratios or some kind of asset based equivalent. 

 

I would say we are about 20% below average for the S&P 500 (1200 to 1300 would be the average).  It needs to be determined on asset values.  Asset values have dropped temporarily but not significantly since they are primarily made up of Property Plant and Equipment.  Therefore the Book Value is not too impaired - maybe 10% maximum across the S&P 500 Universe. while the price side of the equation is way down.   

 

Long term Price to Book Ratio for the S&P 500 (Ned Davis Research is 2.4).  The chart I located only goes to October 17 2008 which is almost exactly where we are now.  So another 30% upside to AVERAGE!

 

http://4.bp.blogspot.com/_m3CQF7whYY4/SQI-Ko558zI/AAAAAAAAA68/2XRczpkUVeA/s1600-h/spy.JPG

 

 

 

 

It is possible that extra factories (and other PP&E items) were built to meet credit driven consumer demand.  In that case, it would suggest we face a lower P/B multiple as many of those assets will sit unproductive until demand swells back to prior levels (which normally happens in a V shaped recovery, but not for a very long time in an L shaped recovery).  So if it's L shaped, then lower P/B would make sense.

 

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Guest kawikaho

Damn, I lost that pdf Sanjeev posted a while back on Buffett's comments on inflation.  It was a lengthy, but highly informative read.  You guys should check it out.

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This is a complicated question and answer.  

 

I think we are somewhere just above or at long-term fair value on the S&P (depending on your inflation views) but that does not mean it can not go way higher or way lower in my opinion - or flat-line for four years.

 

I am thinking through this right now for my portfolio.  Now that ORH, my main position, is being bought out and I can not buy FFH for personal reasons, I am thinking about what to do.  Bonds have rallied and so has the junk in the S&P - but high quality names have not rallied enough.  Say JNJ, BRK, and maybe KO although that is up a lot, might throw in a few commodity-related investments which are tricky, and some good old 50 cent small cap investments if I can find them, maybe a junk bond or preferred.  I think you need a core portfolio generating some earnings yield or spread - to do that, I think I will go long the highest quality names mainly.  Any commodity, junk or small cap will be fully hedged.  This will handle the stock market flat-lining for four years scenario.

 

Then I think I need a hedge both ways: if the stock market / economy / inflation rallies further and if the stock market declines substantially - both of which could happen and I think the latter is more probable but the timing is the question.  These hedges will eat up my core spread but I think I need them for the next 1-3 years.  I'll take one of them off if the S&P rises too high - say 1300 - or descends to low - say below 600.  In between, I think I should sell as the S&P moves one way or the other.

 

I found it interesting that Prem hedged pre-crisis and the guys at LUK made the comment that they were surprised he felt comfortable doing that kind of thing like it was a speculation of sorts.  Seth Klarman hedges often as well for example.  Buffet did as well in his partnership days.  Anyway, I feel more comfortable hedging for the next 1-2 years especially.  Where things are headed are anyone's guess.  Could be inflationary or deflationary.

 

I have hedged my $US portfolio since 1999 against the S&P and the $US about half the time - so 5 out of the 10 years, or 7 of 10 with partial hedges - which has cost me.  My annual compound returns are still in excess of 23% in $Cnd terms with the S&P down 2-3% annually over that time in $US terms and down much much more in $Cnd terms and gold.

 

The point: You can still make money if you hedge and I did not even know what I was doing when I started other than it was clear that we were in a massive stock market bubble in 1999 and the bubble never burst until late 2008/ early 2009.  It is tricky though and I did not make money on my hedges in 2000 believe it or not!  I think I sold on the only day I could have at a slight loss!!! How bad is that?

 

 

 

 

 

 

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Another significant book value item I overlooked for some S&P companies is mortage assets, loans, and insurance policies.  I have no idea how large these would be relative to PP&E. 

 

Another way of doing this is to look at past comparisons to S&P value to GDP and determine the average ratio.  GDP is down a few percent this year.  Bring the S&P to the long term average value and adjust for the temporary US GDP decline.  I have no idea what this will reveal. 

 

I have nothing hedged right now.  I am hedging by selling my higher price and closer dated options on the S&P, FFH, SBUX, and AXP.  Actually sold out my SBUX option position.  Have sold about 65% of my S&P option position and only hold 70 and 75 Dec. 2011 strikes now.  They are so deep in the money they are trading like stock now.  I am keeping cash to buy in when there is a correction - tax loss selling perhaps?

 

 

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The strange thing about inflation, in the 1970s/1980s anyway, is that it seems to have driven down the market P/E, giving cash buyers a chance to get back a fair chunk of their real earnings power after the fact.  Grantham talked a little bit about this earlier this year -- people wanted higher earnings yields to compete with the high short term cash yields.

 

So I know some are thinking about buying stock in great businesses as real assets as an inflation hedge, but the last time around that was not the best play -- it was best to wait for them to crash first.  Then their P/E's reflected high earnings yields that outperformed inflation as inflation eventually subsided.  Same with long term bonds as well.

 

 

 

 

 

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The strange thing about inflation, in the 1970s/1980s anyway, is that it seems to have driven down the market P/E, giving cash buyers a chance to get back a fair chunk of their real earnings power after the fact.  Grantham talked a little bit about this earlier this year -- people wanted higher earnings yields to compete with the high short term cash yields.

 

So I know some are thinking about buying stock in great businesses as real assets as an inflation hedge, but the last time around that was not the best play -- it was best to wait for them to crash first.  Then their P/E's reflected high earnings yields that outperformed inflation as inflation eventually subsided.  Same with long term bonds as well.

 

 

 

 

 

 

We're really far from demand outstripping supply...I don't really see how we get there. 

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This is not easy.  When the US does a Greenspan for 15 years and now Bernanke - a hero for saving the system last year - is arguably just doing a Greenspan-squared.  Wise men do not put themselves into situations where they need agility to save the system.  Kicking the can like this down the road creating a bigger mess in the future - next crisis, its farm, gold, and canned food time.

 

I am not a gold bug, never have been but like Einhorn at Greenlight Capital I am getting religion fast.  I have already started my hedge program for a strong recovery / stock market / inflation by buying out of the money options on silver via the ETF SLV - I don't understand it but a few reasonable investors think its a cheaper play than gold.  I do understand that it is not the $US and they can't print it and that is about all I need to know.  In terms of my deflation hedge, I have out-of-the-money puts on the stock-market reinstated because deflation remains the concern and those guys at Hoisington are probably right.  Like Francis Chou said in his letter, the time to buy the inflation hedge will be when everyone thinks we are headed for deflation again.  Unlike Francis, I don't think you can wait though - you have to buy some now and that is what I am doing.  You may have to double down later but that's fine too.  If everyone knows Obama will stimulate and Bernanke will print as soon as the stock market starts declining back to S&P 800, then that puts a floor under $US assets including housing - preventing deflation seems to be in the DNA of the Federal Reserve because they feel they could have averted the Great Depression if it wasn't for their bad policies then.  So they are hell-bent on not letting that happen this time.

 

It is much simpler to just sit in $Cnd cash - maybe I should do some of that.  Like Buffet, I sure as hell would not sit in $US cash over the long-term unless congress gets serious about the deficit.  In the short-term, if deflationary forces reassert themselves, we could see another big move upward in the $US though.

 

This is not easy.  This is not the way the economy or asset markets are supposed to work.  We will have massive volatility in the economy, asset markets, currencies and price stability.  I think that is my bet for the next 2 years with those hedges going either way.

 

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Fu*@ - would it not be great to just be able to invest as investors used to in the United States. i.e. buy cheap high quality companies, sell, and recycle without having to worry about all this macro shit.  I don't like macro shit but it is the driving force right now.  You can't just go around ignoring it and buy 60 cent dollars right now which is what I like to do.  I mean you need to do that to get some core gains going and that is a value investor's competitive advantage, but I think you need the hedges too because of, on the one hand, these crazy men running the Federal Reserve and Congress not getting the deficit in order and, on the other hand, massive deflationary forces.

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Al,

 

>> Long term Price to Book Ratio for the S&P 500 (Ned Davis Research is 2.4).  The chart I located only goes to October 17 2008 which is almost exactly where we are now.  So another 30% upside to AVERAGE!

 

Not that it matters but, 10/17/2008 happens to be the same date when Buy american op-ed piece by Buffett was published in NYT. Might be a co-incidence.

 

http://www.nytimes.com/2008/10/17/opinion/17buffett.html

 

Thanks.

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Depends on inflation expectations and real growth expectations - back then he thought there would be more of both and then saw just how bad the fundamentals were as well as the deflationary forces.  Now, maybe he'll change his tune again and say look, the real growth is still no good but Bernanke has a printing press making stocks worth more.  We are talking +/- 15% though here in terms of Grantham's flopping on valuations - no big deal, who said this was a precise science.  I am just saying he thinks FV is not 30% higher than were we are now. 

 

The more inflation, the more stocks are worth in the home currency even if the home economy is not growing in real terms.  Problem is, apparently, you should not buy them because the P/E will contract as the market demands a lower multiple because of the inflation.  Not easy.  So what do you buy, can't buy stocks or sit in cash, no bonds, so I think as a value investor you buy stocks because they are worth more even if Mr. Market makes them worth less for a few years.  Do that with half your money, keep other half in cash and buy options on precious metals waiting for those P/Es to contract.

 

 

 

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Wow. I didn't mean to create such a debate guys...

but that's why i like this board so much  :)

 

Thinking about it furthermore this afternoon, I tried to think about it another way. I've started with the idea that S&P500 at 1500 in 2007 was too high, because of all the excesses in the system.

 

How much too high is another question. If there were only 5% of excesses, the market would not have crashed like it did. So I put a 20% figure of exuberance. Let say we lived in a world ruled by responsable and competent peoples, then a fair value of 1200(1500*0.8) for 2007. Compound this at 7%(comes from my creative mind) or whatever growth rate you wanna use to get the fair value of S&P500 for the years after that. This is in a responsable scenario.

 

Unfortunately, there has been excesses causing wealth destruction and wealth stealing. And the consequences of this: high level of debt and government deficits.

 

So where are we now?

 

 

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The strange thing about inflation, in the 1970s/1980s anyway, is that it seems to have driven down the market P/E, giving cash buyers a chance to get back a fair chunk of their real earnings power after the fact.  Grantham talked a little bit about this earlier this year -- people wanted higher earnings yields to compete with the high short term cash yields.

 

So I know some are thinking about buying stock in great businesses as real assets as an inflation hedge, but the last time around that was not the best play -- it was best to wait for them to crash first.  Then their P/E's reflected high earnings yields that outperformed inflation as inflation eventually subsided.  Same with long term bonds as well.

 

 

Inflation does drive down P/E ratios. Main reasons; the market buys high yielding fixed income assets (if and when Chairman Ben decides to raise rates), and they flee US-dollar denominated assets in favor of external currencies and companies in other markets, in our time, this means BRIC. As an example, Chinese markets have gone crazy as of late; 60%+.

What you want to try and do is position your portfolio where the earnings will grow faster than the reduction in the "P" of the p/e ratio.

 

In an inflationary environment what sort of assets and which companies have earnings that go up? That should be your answer. Or else you can get out of the US dollar and invest overseas, which is what the world has been doing the last 6 months or so, as evidenced by the fall in USD. If and when the Fed stops printing and the USD starts coming back up you come back into the game in the US.

 

Personally, I like commodity/resource companies, and maybe some real estate.

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Or else you can get out of the US dollar and invest overseas, which is what the world has been doing the last 6 months or so, as evidenced by the fall in USD. If and when the Fed stops printing and the USD starts coming back up you come back into the game in the US.

 

 

Australia -- few talk about it here.

 

I would not mind being stuck with Australian currency denominated assets given that I'm a dual citizen US/Australia and the place is very nice.  I nearly bought WBK (listed on NYSE) but don't understand banking well enough to analyze it.

 

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Right now I am back to 100% cash (CAN$, being a Canadain investor). I really have a hard time hedging. My returns have been good enough over the years (and again this year) that I can be patient.

 

Will we have deflation or inflation in our near future? My guess is deflation.

What will the government do (direction of public policy)? They absolutely want inflation... makes me wonder if deflation will not be the result in the end.

 

I try to keep things as simple as possible. What is dirt cheap right now (at 10,000 feet)?

- stocks? No

- government bonds? No

- corporate bonds? No

- commodities (incl gold)? No

- real estate (in Canada)? No (still in a bubble)

None of these asset classes are selling today at a 50% discount (my evaluation anyway).

 

I also believe that there is a very good chance that what we are seeing right now is a bear market rally. People remain complacent and greedy (although they now are scared out of their wits due to what they experienced in the stock market and economy at the end of last year). Many people are now exceptionally skittish... another fall in the markets could get ugly as fear permeates though the system and everyone heads for the exit at once. It would not surprise me to see things get ugly enough that many small investors walk away from stocks for many, many years... VERY NORMAL AT THE END OF A BEAR MARKET.

 

Right now all I hear a lot of bullish talk on this board. Greed is rampant. Yes people are concerned about stuff (inflation/deflation/earnings etc) but I get the sense that many want to be where the action is, with the crowd, and be largely invested (yes things have gone up a lot fut they are still 'cheap' becuase.... (fill it in with your own reason).

 

I don't see any $20 bills lying on the street right now. Perhaps I have been spoiled the last 24 months when blood was flowing fast and furiously and many things got crazy cheap. Right now, I am content to sit in cash and wait. If I am wrong, I finish the year with a 29% return (largely due to ORH; thank you AGAIN FFH). If I am right, and things get ugly, let the good times roll (once again)...

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Keep in mind that there are also 'offensive' hedges, & look at UK real-estate.

 

(1) Its cheap & getting cheaper. Various sovereigns & material NA commercial RE coys have quietly started shopping (ie: Birmingham's 'bullring') (2) Brown is advising that the UK will need further stimulus packages for some time to come [additional long term inflation] (3) 4M+ of UK unemployed to force the government hand (4) Long-term UK/USD/CAD FX correction. If you want the FX exposure use a UK property coy.

 

5 years out you might just be surprized

 

SD

 

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