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PATH FINANCIAL LLC

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What can investors do to protect themselves?

Raul Elizalde - Monday, July 25 2011

Markets are finally getting nervous about the debt ceiling negotiations in Washington. Up until recently, both bond and stock markets were calm despite the possibility that talks could collapse. Repeated warnings that a US debt default could be catastrophic for markets did not have a big impact on investors’ minds.

As time goes by, and a final and sensible agreement proves to be increasingly elusive, alarm bells are beginning to go off. Are markets at risk of a substantial decline?

One measure of how markets react to changes in sentiment is the VIX, or “fear index.” Technically, the VIX measures the implied volatility of S&P 500 options. Conceptually, it measures the price investors want to pay to insure a stock portfolio from losses. When the VIX is high, markets are fearful and the price of insurance goes up. When the VIX is low, markets are complacent and the price of insurance goes down.

Many investors have long noticed that when the VIX hits very low levels – i.e. when investors don’t care about insuring their portfolios from losses – markets become more fragile. This makes sense: when investors don’t have many safeguards in place because they are too confident, any disturbance can create a big wave of selling that can take prices down very quickly.

According to a Reuters report, last week witnessed one of the lowest levels of interest in stock portfolio insurance in the past five years, as measured by the number of initiated put option positions. The Reuters report also notes that “when there is little interest in put buying during the past five years, it has usually meant trouble for the market. This lack of put protection is a minor warning sign.”

Our own research agrees: according to our measurements, the low VIX level at the beginning of July is consistent with a 5%-10% market drop within 3 and 5 weeks. That time span would coincide with the beginning of August, when the US is expected to run out of money and start defaulting on its obligations.

Therefore all the elements of a perfect storm that could bring prices down are present: real issues (sputtering debt ceiling negotiations), technical issues (warning signs from low VIX levels) and trading issues (declining summer trading volumes that exacerbate moves). Investors are getting plenty of warnings that the potential for a downside move is high.

On the other hand, it seems quite evident that the US does not have a solvency problem. The US would not default on its obligations because of a structural inability to service its debt, like Greece, but rather because of a misguided political decision. Of course, there is a chance that the nation could actually benefit in the long run if the current fight over fiscal policy improves the trajectory of debt and deficits without creating an economic “double dip.” This scenario, however, requires a high degree of confidence that US policymakers will put a better national future above their narrow political interests. So far this appears hopeful at best.

What should investors do? Cautious types may want to reduce risky positions now, before the beginning of August, and increase the levels of cash in their portfolios. Note that increasing allocations to typical conservative positions – US Treasury bonds and notes – may actually be detrimental to portfolios if the US is downgraded, which would depress the price of bonds. Cash, or very short US Treasury bills, may be a safer bet.

More sophisticated investors may want to buy some protection in the form of put options, but these instruments are complicated and have expiration dates. This is only an alternative to those with the necessary technical knowledge – and the willingness to watch markets during the day.

Finally, those who are reluctant to liquidate their holdings could try to sit this one out, and redouble their vigilance in case things take a turn for the worse. This may well be the best strategy for those who believe that there is a chance that US policymakers may actually get it right.

Summer is typically the time when people try to relax and escape the heat by going to faraway places. But investors rarely find the summer relaxing, and this one is no exception. The payoff for heeding warnings by remaining alert and nimble, however, could be big this time around.

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We use quantitative measures to build and maintain portfolios for our clients, which we rebalance every quarter. We described our investment process in previous newsletters. If you would like to know more about how Path Financial’s investment process works, call us or send us an e-mail at the address below. We’ll be happy to set up a confidential meeting to discuss new paths to financial success.

Raul Elizalde | raul@pathfinancial.net | 941-350-7904