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Lawrence Ullman is the chief executive of Ullman Wealth Management Inc., which provides private capital-management services to high-net-worth individuals, endowments, charities and foundations.

This year’s market rally has caught many investors off guard. This was supposed to be the year that brought the harsh reality of higher rates to a theatre near you. But the script went a little differently than expected as equities caught a break from underinvested managers, a resilient economy, falling inflation, and a little help from momentum provided by generative artificial intelligence.

But if stock market participants were underinvested early in the year, they’ve since been lured back into the water. So much so that a recent Bank of America Global Fund Managers Survey revealed that allocations to equities are the most bullish since April, 2022, and cash levels are the lowest since November, 2021. Yet this is happening in the face of stubborn inflation, rich stock valuations and soaring bond yields.

Indeed, what is an equity investor to do knowing that certain formidable headwinds remain? The Fed is raising interest rates in the midst of an extended and richly valued equity market. The S&P 500 trades at an approximate 20 times forward price-earnings multiple. (Over the longer term, average P/E ratios are in the region of 17.3.) Based on the current high-interest-rate environment, market participants seem to be assuming material interest-rate cuts in 2024 to justify this valuation level. However, investors may already be sensing a reckoning is coming, with the index struggling in the second half of August.

But what if they’re wrong and the outlook for these rate cuts becomes uncertain? Or worse, what if central-bank rate hikes continue for some time given still-elevated inflation, which in Canada has shown recent signs of becoming more entrenched?

This scenario may not be far-fetched – bond investors have been acting more concerned, with two-year Treasury yields recently reaching 16-year highs, spurred in part by strong jobs data. After many years of meagre yields, investors now have an alternative. As a result, surging yields may pressure investors to adjust equity allocations, away from growth sectors in particular.

From a seasonal perspective, equity market volatility as measured by the CBOE Volatility Index tends to bottom out in June, only to begin a steady rise in July through to October. We note that this past June saw particularly low volatility as equity investors covered short positions and a pronounced fear of missing out (FOMO) took hold. But the October effect of more elevated volatility may soon be upon us.

To be sure, a trillion dollars of excess cash, as compared with levels prior to the pandemic, may help to prevent the harder landing some have predicted – but what if the party is now extending into the later hours of the night? Interest-rate hikes do tend to take some time to have an impact on the economy. Investors have had a good run this year and stocks currently trade at significant premiums versus bond yields.

Considering the material and abrupt pivot toward increased risk appetite over the past six months, investors are now increasingly asking the question of how to protect their portfolios in the context of global central-bank tightening and continued increases in policy interest rates. It may be time to consider some more defensive strategies.

One such strategy would be to purchase the Cambria Tail Risk ETF (TAIL-A) in the United States. This fund owns puts – which allow the holder to sell a stock at a predetermined price in the future – that should perform if the S&P 500 falls to various strike prices currently between the 4,200 and 3,600 levels. Keep in mind that these kinds of funds are intended as hedging vehicles for shorter holding periods. Over time they may lose value in more stable market environments.

A second idea would be to buy out-of-the-money call spreads – an option to purchase a stock above its current price – on the VIX. This could capitalize on quick periods of market instability. These kinds of positions are less a direct play on markets falling as they are on volatility rising. As such, they require proper execution, monitoring and a strategic closing plan.

A third option would be to purchase the iShares 7-10 Year Treasury Bond ETF (IEF-Q) in the U.S. and combine it with a major bank floating-rate bond. IEF gives the investor exposure to medium-term bonds. The fund did very well in the market meltdown of 2020. IEF is also U.S. dollar denominated so the product plays double duty as a holding that has safe-haven U.S.-dollar exposure. The floating-rate note resets quarterly based on prevailing rates, so that if rates continue higher you can benefit. So, think of IEF as potential crash protection, while the floating-rate bond pays off if short-term interest rates continue to head higher.

A hedging basket comprising several or all of these strategies could do well to insulate you for a period of time against a sharp reversal of recent stock market outperformance, without having to trigger a taxable event by selling your current holdings.

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