Beat the System: Want to protect your stock-market gains?Consider these options
If you are one of those investors worried about this high-flying stock market and are looking to protect some of your gains, you have several ways to do it.
Whether cash, long-term Treasury bonds, gold or derivatives, each offers the potential to protect against the ravages of the next bear market. But none is perfect, and each has its critics.
Warren Buffett likes to say that investors should be greedy when others are fearful, and fearful when others are greedy. It’s hard to argue that the market looks pretty greedy right now.
The boom in global markets this year has taken many indexes, including the S&P 500 SPX, -0.09% , the Dow Jones Industrial Average DJIA, -0.20% , and the Nasdaq Composite Index COMP, -0.01% , to new highs. At current levels the S&P 500, the broadest index, is trading at an eye-watering 31 times average corporate earnings of the past 10 years, a measure known as the Cyclically-Adjusted Price-Earnings ratio.
The historic average, going back to the 1870s, is 16 times.
Read: What $ 1,000 invested in each of 15 popular stocks before the Great Recession looks like now
The last two bear markets on Wall Street saw the stock market fall more than 50% before it bottomed out. Neither bear market was predicted by Wall Street’s usual suspects. And there may be some technical reasons to suspect the big boom, which began in 2009, may be running out of steam.
Read: Goldman Sachs says ‘rational exuberance’ to drive stock market in 2018
Investors who cash in some of their profits and hold the money in Treasury bills, money-market funds or bank deposits will miss out on any further stock market gains just as they will miss out on any further losses. They’ll also face a potential tax bill on capital gains on investments sold in taxable accounts, ranging from 0% to 39% depending on their tax bracket and how long they’ve held the stocks or funds.
It’s another reminder of the advantages of tax-deferred accounts such as 401(k)s and Individual Retirement Accounts, where this kind of shift can be done without paying capital-gains tax.
Long-term Treasury bonds have typically offered a more dynamic form of protection. In financial or economic crises they have generally risen sharply in value as investors seek their security and protection. Some very long-term Treasury bonds doubled in value or better during the 2008 financial crisis. Those who held a small amount of their portfolio in long-term Treasurys got a cushion in the meltdown, as those prices went up while just about everything else went down.
The most focused form of Treasury “insurance” bond is a so-called zero-coupon bond, also known as a “STRIP,” on a 30-year bond. This consists of a right to claim the final payment only of the 30-year Treasury. These should rise the most among all bonds in a crisis, and also require the least capital commitment.
Such bonds are relatively easy to buy, even through a basic retail broker. Currently 30-year Treasury “zeroes” offer a yield of 2.8%.
Putting money in cash involves no other fees or risks, of course, and is simple to do. But yields on a money-market fund, for example, will be even lower.
Holding some gold in the portfolio as a protection offers higher risks as well as rewards. Gold has often been called a “safe haven” in times of economic or financial crises, but its track record isn’t as great as its fans want you to believe. On the other hand, investors argue gold may offer protection against inflation and currency devaluation.
Potentially the best way to protect against a market slump is to buy insurance in the form of “put” options on a broad market index like the S&P 500. Such options are effectively wagers that the market will fall. They can offer small commitments and big payouts if the timing is right, but otherwise they will expire worthless and the money is gone.
With the S&P 500 trading around 2600 right now, put options which expire in two years’ time trade at $ 221. If the market falls they will pay out the difference between the index close two years from now, and the 2600 purchase price.
So if the S&P closes at 2000, say, that’s a 600-point fall and the option would expire worth $ 600 — a 170% return on the initial stake.
An S&P at 2000 would still trade on a lofty CAPE of 25. If the index fell all the way to its historic average of 16 times, that would take it down to around 1400. That be a fall of 1200 points, meaning a $ 221 contract would be worth more than five times the initial stake. Most reputable brokers offer advice to clients on how to trade options, and investors have to sign a consent form saying they understand the risks.
The complexities are why so many investors stick with just cash — and others just hang on and hope for the best.