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Insurance in an overvalued market [ClearOnMoney]
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Insurance in an overvalued market

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Investment

Insurance in an overvalued market

11 Apr 2010 by Jim Fickett.

I have closed out one insurance position – Proshares ultrashort – which I held too long, and opened another – a put option on the S&P 500 index.

The stock market is overvalued. In Range of stock market outcomes I presented results from Prieur du Plessis, suggesting that at today's Cyclically-adjusted Price/Earnings (CAPE) ratio (21.3 as of March), expected 10-year returns are only 3.4%, and the possibility of negative 10-year returns is significant.

In yesterday's post, 10-twelve_major_trends_and_mr._market, I looked at the way some major trends might influence the market over the next few months. This was an attempt to let the data speak for itself, and it suggests to me that a move down to somewhere nearer the long-run average of CAPE (16.4) is reasonably likely. To go down to 16.4 would be a drop of 23%.

In February the market was only slightly less overvalued. In addition, sentiment seemed to me to sufficiently negative that we might be near a turning point. I bought a small position in Proshares ultrashort which, on a daily basis, returns twice the inverse of the S&P 500. The guess that we were near a turning point was wrong, but I don't think it was a bad guess given the data at the time.

However I held the position until last Friday, and that was a mistake. During most of the intervening period it was quite clear that faith in a strong recovery was pervasive, and the market was rising. And as Barry Ritholtz recently wrote:

Whether a premise is fundamentally true or false is irrelevant as to whether it is actionable. If enough fools believe something is so, it will impact the markets.

I don't believe we are in a strong recovery, but many people do, and I lost 17% on the position. Fortunately it was a small bet.

What now? I would give about even odds for a drop in the neighborhood of 20% by the end of the year. Since optimism is high, insuring against such a drop is relatively cheap.

XSP can be thought of as an option on a virtual stock with one tenth the value of the S&P 500. The S&P 500 closed Friday at 1194.37. So with the usual convention that one options contract covers 100 shares, an XSP contract covers a notional value of $11,943.70. I bought to cover about 5% of my portfolio, with a Dec 2010 expiry and a strike price of 115, at a cost of $6.50 (i.e. $650 for a contract). So I would break even with the S&P 500 at 1150 - 65 = 1085, which is about 9% below Friday's level.

One important detail is that this option can be exercised only on the last day, in my case the end of Dec 2010. However it can, of course, be sold at any point of pessimism before then.