Anything For You All: Stock market hedging as we know it is broken — but there's a new way to protect against a meltdown

Stock market hedging as we know it is broken — but there's a new way to protect against a meltdown

Hedging methods that have worked for years have broken down, leaving investors wondering how they can protect their hard-earned gains from a market meltdown.
Fear not, for there are hedging solutions that go beyond the traditional practices of simply buying US Treasurys and the dollar as protection.

Hedging isn't as easy as it used to be.

Until recently, an investor looking to protect against stock declines could simply purchase long-term Treasurys or US dollar futures, the logic being that the assets traded inversely to one another. If stocks went up, the other assets would go down, and vice versa.

But that relationship has broken down, derailing the strategy and leaving investors wondering how they can protect their hard-earned gains from a market meltdown.

This chart, from financial services firm INTL FCStone, shows this dynamic in action. It highlights how negative correlations between stocks and both the dollar and Treasurys have risen and gotten closer to zero, or, in the case of the dollar index, even become positive — suggesting a decline in hedging efficacy.

"The correlation between the US dollar index and stocks has already flipped, and long-term treasuries are no longer a perfect hedge against stock market volatility," INTL FCStone macro strategist Vincent Deluard wrote in a recent client note. "This change has gone largely unnoticed."

But why? How could investors be so blind to such a drastic market shift?

Deluard notes that when stocks are going up everyday, investors eschew hedging activity. And equities have certainly soared in recent months, hitting a seemingly endless streak of new record highs, lulling traders into a dangerous sense of complacency.

So with this all established, what's the way forward for investors who want to hedge, but can't go their normal route?

Deluard breaks down what he sees as the three best possibilities:

Buy equity put options that are attractively priced at the moment — Deluard notes, however, that this is an incomplete hedge, since it only protects against losses in stocks, not bonds or the dollar.
Find a new "risk-off" asset to buy when things get rough — Deluard recommends gold, the Japanese yen, and the Swiss franc as ideal candidates to replace Treasurys and the dollar.
Buy high-quality floating rate corporate bonds and long-dated oil futures — Deluard says that these protect against the two biggest risks of 2018: rising rates and inflation.

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