Despite historically high valuations, investors seem to be ignoring the risks inherent in equities, even as the major market indexes soar to record levels. Additionally, there is "elevated geopolitical and policy risk globally" that could send the markets plunging, warns Nikolay Angeloff, equity derivatives strategist at Bank of America Merrill Lynch (BAML), in a research note quoted by CNBC.
Indicative of what may be irrational exuberance in the stock market, Angeloff indicates that, as of his writing on Oct. 24, 334 days had passed since the last 5 percent pullback, the fourth-longest stretch of this kind since 1928, just before the 1929 stock market crash that preceded the Great Depression of the 1930s.
Angeloff suggests a defensive options strategy for investors right now to protect their stock portfolio.
Gina Sanchez, founder and CEO of asset allocation modeling and consulting firm Chantico Global LLC, is equally concerned about the equities market. She told CNBC that "if you look at that complacency, it's largely been fed by a huge drop in correlations. Basically, you are diversifying away all risk, meaning the underlying stocks are much riskier than the aggregate looks like."
BAML's Angeloff says there's a way for investors to protect themselves, at least near-term, and it requires a seasoned market player to execute it. He said that hedging against a decline in the S&P 500 Index (SPX) is at its "most attractive level in 15 years." The S&P 500 opened Wednesday at 2,566. He recommends buying near-term at-the-money put options on the index. That is, options expiring in the near future that allow the buyer to sell the index roughly at its current value. Thus, if the S&P 500 plunges before the put options expire, the buyer will be able to lock its current value, less any option premiums and brokerage commissions paid.
In addition, he indicates that an investor can finance the first trade by selling put options that expire in June 2018, suggesting contracts with a strike price of 2,275, which is slightly more than 11% below the current value of the S&P 500. The catch is that the investor must be comfortable with the notion of buying into the S&P 500 at a price of 2,275. If the index falls below that level, the put options are likely to be exercised, with the upshot that the investor will be forced to buy the S&P 500 at 2,275, even if it has fallen significantly more.
Indeed, a correction of 11% or so is relatively modest by historic standards, and long overdue. It also is minor compared to the bear markets of 2000-02 and 2007-09, in which the S&P 500 shed half or more of its value, as charted by Yardeni Research Inc.
Other Defensive Strategies
There are other approaches beyond options to protect against a down market. One is to shift equity investments into higher-quality companies, while also diversifying internationally and regionally. Advocates of this strategy warn that just rushing headlong into bonds can be a mistake that adds to risk, rather than reduces it. (For more, see also: How To 'De-Risk' Your Stock Portfolio For A Crash.)
Another alternative is to seek out companies with high returns on invested capital (ROIC). Research indicates that during the last bear market, stocks with high ROIC were prominent among those that bucked the trend and actually posted strong gains. (For more, see also: Which Stocks May Outperform in the Next Market Crash.)
Strategist Michael Belkin, whose model correctly predicted market tops in 2000 and 2007, recommends several cheaply-valued defensive stocks with attractive dividend yields. He also suggests various overpriced or over-owned shorts. (For more, see also: The Apocalypse Stock Portfolio: One Strategist's Picks.)
Also, Bank of America Merrill Lynch sees value in banks and health care stocks, believing that they can maintain value even in a selloff. (For more, see also: 2 Big Safe Havens if the Stock Rally Crashes.)
While there's no perfect way to defend a stock portfolio in the case of a plunging market, many big investors agree it's wise to take steps to protect your assets in case the worst happens.