How I'm Protecting My Portfolio From a Market Shock
A variety of factors could disrupt the markets and the economy in the year ahead. These bear put spreads provide inexpensive insurance.
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Valuations continue to get more and more stretched as the major indexes pile on one all-time high after another. The S&P 500 is looking mighty frothy here at nearly 22 times forward earnings, especially when the Fed Funds rate is still north of 5%.
The AI build-out frenzy has been a powerful driver to this rally, and one of the few in this market. As Bespoke Investment noted late last week without this investment theme, the S&P 500 would likely be trading some 20% lower than where it currently is.
Doug Kass noted on Thursday in his Daily Dairy, how Nvidia NVDA and four other large tech stocks, including Meta Platforms META and Amazon AMZN, have accounted for about 60% of the overall market’s performance. This is something that hasn’t happened since the 1960s during the Nifty Fifty days. In addition, without the seven largest tech names in the market, overall corporate profits would have dropped both in the fourth quarter of last year and the first quarter of 2024.
Domestically, we have a clearly slowing economy compared to the back half of 2023. The consumer also seems to buckling now that all the excess savings from all the Covid stimulus programs have been spent, and we are less than five months away from what promises to be a very divisive election.
Meanwhile, the residential real estate market is somewhat moribund and a headwind to the economy. The situation in the commercial real estate market continues to deteriorate. Defaults and delinquencies on debt related to CRE will continue to rise. This will be a major headwind to community and regional banks at a time that banks are already dealing with over $500 billion in unrealized losses on their bond portfolios.
Globally, the proxy war in Ukraine continues to escalate with no off ramp in site. The regional war involving Israel also looks like it could also expand, and the Houthis will continue to subject shipping going through the Red Sea to missile and drone attacks.
Late last week, the French bond and stock markets plunged as it looks like President Macron might be given the boot after snap elections in a few weeks. The spread between French and German sovereign debt widened to its largest level since 2017 as there are concerns the next leg of the European debt crisis could be on the horizon.
As you can see, there are a lot of potential factors, both foreign and domestic, that could disrupt the markets and the economy in the year ahead. Especially with equities trading at such extended valuations.
A bear market is not my baseline scenario, but I put the chance of one sometime over the next year at between 25% to 30%. This is why I have approximately 2% of my overall portfolio in long-dated, out-of-the-money bear put spreads against index ETFs that will pay off approximately 10 to 1 if we do see a 20% drop in equities over the next year. With the VIX trading at its lowest level since 2019, this is cheap insurance for the rest of my portfolio. I have outlined one such trade below.
Option Strategy
This is how I executed a long-dated, out-of-the-money bear put spread against the SPDR S&P 500 ETF Trust SPY late this week.
Utilizing the June 2025 $490/$430 put strike pair, execute a bear put spread order for between $6.25 to $6.35 a share. If the SPY declines 20% from current levels over the next 13 months, you will collect $60.00 a share for your $6.30 position. A decline of just 11% will also put the trade in the black.
At the time of publication, Jensen was short SPY via bear put spreads.
