Advisers who don't hedge against a bear market should remember that they could be more at risk from the stock market than their clients, according to a white paper by Meb Faber, chief investment officer of Cambria Investment Management.
As much as clients fear a bear market, advisers should, too. A bear market increases the odds not only of personal loss, but loss of clients. (And if you work for a larger employer, keep in mind that financial services firms have a tendency to put employees out on the street during market downturns.)
The paper argues that the market is long overdue for a correction, and that a permanent put option strategy is best for clients and advisers.
The warning signs:
• Bull markets don't die of old age, but they don't live forever, either. The current bull market started March 9, 2009, and is now 78% longer than the average bull market.
• Stocks aren't cheap. Warren Buffett's favorite measure of stock valuation is comparing the value of the stock market to U.S. gross domestic product. It's now about 30% more expensive than GDP — not as hugely overvalued as it was in 2000, but higher than it was in 2007. The Shiller 10-year cyclically adjusted PE ratio shows similar overvaluation.
• Investors are awfully cheerful, according to sentiment indicators. That's not usually the time to buy stocks. And the market has shown less volatility than a brick.
All of which doesn't necessarily mean a bear market is around the corner.
"We all know markets can keep climbing far past the point logic would suggest otherwise," Mr. Faber wrote.
Traditional defensive strategies include diversification among asset classes and international markets, but, with the exception of cash, they have spotty records against bear markets, Mr. Faber said. Buying out-of-the-money puts on a U.S. stock portfolio provides good bear market protection.
But insurance isn't free, and those put options won't help a portfolio in a bull market. And that means that over the past 30 years, adding puts to a portfolio hasn't beaten the S&P 500. So why bother?
Everyone, in theory, is a long-term, buy-and-hold investor — at least until there are big, scary downturns. A hedging strategy can reduce those, as well as the risk that a client will demand to get out of the market at the wrong time.
"Lower drawdowns are much easier to stomach, and in a real-world setting, would do a vastly better job at preventing panic-selling. Given this perspective shift, I would argue the permanent hedge does help — significantly — despite the costs involved," Mr. Faber wrote. "That's because it's more likely to keep your money invested, working for you."
And, he said, it's more likely to keep you working.
"For advisers, [a falling stock market] impacts their personal portfolio, their shorter-term business income, potentially their longer-term business income, and in dire situations, the viability of their company," he wrote. "Many investors can reduce their equity exposure, but many advisers and investment companies cannot."