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Which Market Camp Are You In?


Examine the S&P 500 PE ratio to see how this market will affect hedging.

Are we four years into a six- to eight-year secular bull market? Or are we near the end of a four-year market recovery driven mostly by the Fed's quantitative easing?

While this question is straightforward, it is by no means simple. Answering it is the key to unlocking untold amounts of wealth. In fact, the questions don't end here. For instance, even if you thought we were at the end of a four-year recovery, you would need to have a hypothesis on what happens next. Does the market just move sideways or does it decline? If it declines, does it occur sharply or slowly over months or years?

I'm not trying to time the market here; I'm just trying to gauge whether our hedges should be modified. Should they be strengthened to have a higher delta for the near-term six-month window, or can I stretch them out over two years in anticipation of the continued bull market?

These are hard decisions to make. I have mostly been in the camp that believes that this market is significantly overvalued when you look at the recent earnings power of the companies that make up the market. Look at the below chart, courtesy of, which shows the S&P 500 (INDEXSP:.INX) PE ratio over the last 140+ years.

As you can see, the current multiple of 18x on the trailing twelve months of actual EPS is nowhere near an all-time high. If you ignore the PE multiple spike in 2008/2009, the highest multiple is near 45 during the Internet bubble of the early 2000s. (Note: You ignore this spike because at this point, financials had significant negative earnings that dragged the earnings levels so low that the multiple was unrealistically low.)

So, on a PE multiple basis, the current levels are not high on a historical basis at all; these kinds of levels have been seen on a regular basis throughout history – over and over again, in fact.

A further look at the Shiller PE ratio from adjusts for inflation and uses a 10-year earnings average, which smooths out bumps like 2009. This chart again confirms that we have seen several markets in the past with higher valuations than we see now.

So while I have been in the camp that believed a pullback was imminent, I am now giving into the real possibility that we could have two to four more years of a secular bull market. I give it at least a 40% chance of happening.

What does that mean for hedging?

For my firm's clients, any new money being put to work will have hedges bought with particularly long expirations – think two years out, if possible. But to be safe, we will counterbalance the long duration with a closer threshold for being hedged – meaning that we will set the protections closer to the money. Not at-the-money, but just closer to the money.

And we will likely look to roll these two-year hedges with one year to go before expiration in order to preserve the time value in them. This is especially important if the market bull continues its trend.
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No positions in stocks mentioned.
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