Larry Berman: Time to use this strategy to protect against a market pullback

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Donald Trump told Americans last week to "get out of stocks" just like he did. He said that artificially low interest rates set by the Federal Reserve are inflating the stock market. Of course, this has been the case since the end of 2013 when earnings multiples expanded significantly with virtually no material growth in earnings and a huge increase in quantitative easing. While I believe the valuation of the U.S. market is not attractive and that correction risk is very high, selling everything may not be ideal depending on your tax situation.

Timing the market is very difficult. This statement is coming from someone who had made a career focused on making asset allocation decisions. To be clear, any decision that is not a buy-and-hold tracking of a benchmark or an index (exchange-traded fund) is a form of market timing. All active portfolio managers have some methodology for the timing of their market decisions. Some are based on fundamentals, some on quantitative ratios, others are technical or behavioural and others on a hybrid of all techniques – I fall into the hybrid category. I find it funny that 99 per cent of the industry says do not try to time the market, yet everyone does it.

One of the best tried-and-true strategies when the markets are making new highs and valuation is not attractive is to buy some insurance. When markets are at a high point, volatility is typically very low, which means that put options are inexpensively priced. The biggest factor in options pricing is the implied risk or volatility embedded in the cost of buying put insurance. A put is a contract that gives you the right, but not the obligation, to sell a security at a fixed price. If the market falls below your option strike price, the price of your option goes up, offsetting the loss in the portfolio.

The chart this week shows the implied volatility is at an extremely low level for the next three months, which would cover you right into the U.S. election. While it seemed as if Mr. Trump said everything he can to lose the respect of the GOP and the independent voter, we would not rule him out just yet. You can see that once the market is already down, the cost of protecting your portfolio moves significantly higher as we saw in August, 2015, January, 2016, and February, 2016. So the time to protect your portfolio is when the market is still high and the potential risk is rising.

The cost of an October put on the iShares S&P 500 ETF at $24 (U.S.) – which is about 4 per cent below the current market price – is about 45 cents, or less than 2 per cent of the cost of the ETF. So to insulate your portfolio for the next few months for a correction greater than about 5 per cent would cost you about 2 per cent. So, rather than selling everything as Mr. Trump suggested, to time the market sell about 2 per cent of the holdings more economically sensitive to falling markets to raise cash needed to purchase the put protection. In taxable accounts, this is the best strategy rather than selling everything and triggering a capital tax event. Of course, if the correction turns out to be less than 5 per cent, you lose the 2-per-cent option cost, but maybe you sleep a bit better knowing you are protected.

In a registered account, selling everything does not trigger a tax event, but it does trigger an emotional one if the market keeps going higher. So here too, you may not want to sell everything and employ a cheap option strategy. If Mr. Trump is wrong and the market gets even more irrationally exuberant, you will still likely make some money on the 98 per cent of your portfolio still invested.

While I hate to admit that I agree with Mr. Trump, I do see the market risks as high. I've been making money for clients holding positions in the U.S. dollar the past few months as our dollar has weakened. The recent employment and trade reports for Canada were awful and when combined with the stronger U.S. employment reports in the past two months, the odds of the Canadian dollar falling a few more cents in the third quarter is a conservative way to make a few bucks with your cash.

Larry Berman is co-founder of ETF Capital Management. He is a Chartered Market Technician, a Chartered Financial Analyst charterholder, and is a U.S.-registered Commodity Trading Advisor.