(cos it’s a hedge…geddit? 😀 )

The longer we get into this bull market, the more I feel that the stock market is at a key inflection point. My (unresearched & unfounded) suspicion is that the market may either be able to move past the current uncertainty and climb higher despite the rich valuations especially in the US markets OR (more likely) investor sentiment will turn increasingly bearish and falling prices/significantly negative event will encourage more selling and a downward spiral. I don’t have a timeline for this and the scenarios above may take years to play out.

To be clear, the SippingCoconuts portfolio is largely invested in Singapore and emerging stock markets with a smaller portion invested in individual picks of US listed stocks . While technically we don’t need to be worried if only US valuations are stretched, markets are increasingly correlated and therefore will likely move in tandem if US markets drop sharply.

What should SippingCoconuts do in such a situation? While we are long term investors in the stock market, we don’t believe exclusively in the strategy of passive buy and hold of an index ETF. That may surprise some as it runs counter to the usual strategy of most in the #FIRE community. We just think that it’s best to have a flexible strategy especially since index investing is a crowded trade and there are indicators of a divergence in the valuation of the largest US stocks with the rest of the market.

Anyway, I’m not a market forecaster so don’t read too much into my feelings above and let’s get into the hedging options SippingCoconuts is currently considering. 😀

Hedging Strategies

1. Sell it all and run for the hills!!!

Yes, you could sell out 100% from the market into cash/gold/bitcoin (or whatever else tickles your fancy) and stay out until the markets drop. While this might be tempting because then you’d no longer be exposed to market risk, there is the potential opportunity cost of further market gains (I’d say don’t be greedy) and the almost definite inflation that will erode your wealth and purchasing power. Depending on the stage you are at in your #FIRE journey, selling out will also mean you lose your source of passive income, which sucks if you have already retired and depend on that passive income. In the case of the already retired, if the dividend income is already sufficient for your spending needs, you could probably ignore the price fluctuations and just do nothing since you don’t need to sell any of the principal.

2. Sell out of average stocks/ETFs and invest only in defensive stocks

This seems pretty attractive to me because I don’t really have a good fundamental understanding of ALL the underlying constituents of the index ETFs we’re invested in. Sure I know the largest constituents companies and surface information but with a lack of detailed research into each, my conviction in the ETF is less than my individual stock picks. Some might say that doesn’t matter because the prices will eventually rise again and an index is self-replenishing (i.e. under-performers will get replaced). However, I wouldn’t bet my retirement on that and history has shown that markets can remain depressed for longer than commonly thought….decades even.

With the funds from selling ETFs, I would like to allocate part of the funds to a basket of defensive stocks. My criteria (which I’m still formulating) will likely be little to no debt or a net cash position, stable and profitable business, and reasonable valuations. In fact I’ve been adding to quite a few SGX companies where their cash holdings are a significant portion of market cap. As a basket of stocks, I think this will do well over the medium to long term and I will also sleep better at night due to the high cash holdings.

Some might consider things like utilities or liquor/tobacco stocks as being defensive. Maybe…at the right price.

3. Special situations

The idea here is to invest in stocks with specific catalysts to unlock value within a finite timeline. The situation could be privatisations, mergers, spin-offs, bankruptcies/restructurings, and the likes. As the inception of the investment is dependent on events outside my control, this won’t be a major thrust of the strategy and will more likely be opportunistic as and when things arise.

4. Long/Short strategy

In conjunction with options 2 and 3, or maybe even while remaining fully invested in ETFs, one option to hedge would be to short stocks which have been identified as being overvalued. You could do this by traditional borrow and short but my preference is to use options despite the time decay. A collar or more complex strategies could be executed to reduce the cost of the hedge.

5. Alternative asset classes

The idea here is to invest in something that is negatively correlated with stocks to preserve the value of your portfolio should stocks decline. This could be commodities, bonds, real estate, wine, or whatever else (don’t do Bitcoin….no!!!). Having said that, we don’t intend to allocate more funds to any of the above.

As of now, most of the non-stock part of our portfolio is the equity in SippingCoconuts’ home. In fact, I’m thinking of de-risking our portfolio further by selling one of our under-construction investment properties in Malaysia although the place is going to be gorgeous near the marina because I don’t think the rental demand in that location will be very good in the near term. So I’d rather sell it and get off the hook for future mortgage installments so that our fixed cash outflows are reduced further.

6. The ultimate hedge

Continue to generate more active and passive income and save/invest!

Conclusion

As mentioned above, the SippingCoconuts portfolio will be repositioned to be on the defense so that our overall market risk is reduced. I think the combination of increasing our cash balances, continuing to invest in value stock picks or special situations, and going short on specific overvalued counters/markets will allow us to have moderate growth (in a benign market) or at least reduce our capital loss (if there’s a major crash).

What are your thoughts or questions? Am I crazy for hedging too early? Or do you have other ways to protecting your portfolio that you wish to share? Do comment below! 😀