Market Observations at the end of the Year of the Fed

by Wayne Ferbert on December 19th, 2013

Some might say that yesterday was the Santa Clause rally. In the past, Santa didn’t need the Fed to step in to help the rally. But, this is 2013 – the year of the Fed.
A few observations going in to year end:
1. The hypothesis for most investors has been that the taper would mean the Fed is pulling back the party punch – and most have assumed that would mean the market would start to pull back. The opposite happened this week. The taper was so small but there was a more important factor: the Fed took GREAT PAINS to make sure that investors understood the Dovish forward Fed outlook.
The Fed spent time explaining that the Fed would still be using the might of its balance sheet to great effect. In addition, they pointed out that interest rates in t he form of the target rates would be kept low thru close to the end of 2015. In other words, the Fed announced that the party punch would be here for a while.
The result: the risk-on trade can continue in to 2014.
2. As a Buy and Hedge investor, you are hopefully deploying a laddered hedge. And you more than likely use the quarterly options to do it. The regular monthly options expire tomorrow – and I can’t think of a better spot to be setting new hedges. The markets are near the highest levels ever. Hopefully, your new floor will be the highest you have ever set. That is my Christmas wish to you.
3. Let’s remember that it is year end – and time to tax plan. If you have gains from this year and you have some deep OTM hedges that expire in March or June 2014 that have already lost a lot of their value, think about selling them and rolling to new levels and/or new months. That realized loss can help you manage down your tax bill in April.
4. If you like Christmas and you are like me, you like to get the year-end Christmas cards with the pictures that show how your friend’s kids have grown. It is especially nice to get them from those far-away friends that you don’t get to see very often. But the coolest Christmas card I have seen this year was this online video Christmas card. Check it out. Its very funny and the wife is easy on the eyes! --
5. Lastly, Jay and I want to thank all of our readers and clients for their continued support thru 2013. Our business more than tripled in assets in 2013 and we have a lot for which we are thankful. Merry Christmas and Happy New Year!

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Daniel - January 11th, 2014 at 10:09 AM
This is a general question as a "newcomer" to the site, having finished reading the book(which I enjoyed very much and thank you so much for a well done job): If the cost of hedging is 5-8% of portfolio/year leaving another potential loss of capital at risk of 10% - this means a "black swan" episode insurance will cost in me 15-18%. Now , when I look at my quite diversified portfolio S.D it is a mean of about 15% for the last 20 years. My question: Isn't a well diversified portfolio combined with a buy&hedge strategy = over insured approach? (I am paying too much to protect myself).

- January 13th, 2014 at 3:49 PM
The cost of hedging fluctuates over time. And because it can be high sometimes (~6-8%), we recommend selling your upside with a short option - like a short call. It is the only way to bring your cost of hedging in line and make it more reasonable. Otherwise, yes - the cost of hedging can get expensive.

That said, you need to change your hedge based on the dynamic market. For instance, right now you can get 1-year out protection on the S&P500 right AT THE MONEY for about 6% cost. That is very low.

10% down protection for 1 year out costs about 3% - another very low amount.

I like closer to the ATM protection levels right now given the low cost to hedge!

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