This story appears in the May 4, 2014 issue of Forbes. Subscribe
What do you do if the market is 43% overpriced? (The 43% is explained here.)
Go to cash. James Montier, bearish market strategist at money manager GMO, is only 30% invested with his own savings. That’s a bit drastic, but you could lighten up. You could unload some stocks you’re not fond of.
This is not a costless move. While you’re on the sidelines you’ll be getting a real return (interest minus inflation) between minus 1% and minus 2%. Also, you might owe capital gain taxes on the sale of the stock.
Inside a 401(k), of course, a reallocation like this has no tax impact.
Buy an option. A put contract on the S&P 500 index with a strike price of 1,800 and an expiration in December 2015 was recently trading, on the Chicago Board Options Exchange, near 160. That means you shell out $16,000 and collect, on expiration, $100 for every point that the index closes below 1,800.
It’s a risky bet. If stocks go sideways or up your $16,000 goes down the drain.
A contract of this size would protect $185,000 worth of stock, assuming your portfolio resembles the S&P 500. The insurance wouldn’t kick in until you had lost $5,000, and it wouldn’t pay enough for you to recoup the $16,000 premium until your $185,000 portfolio had shrunk to $164,000.
Who’d buy insurance like that? Someone who owns a collection of low-basis shares in a taxable account and doesn't want to run up a capital gain tax bill by selling them.
The futures contract, on the other hand, is subject to immediate tax, even before you close it out. As a "Section 1256" investment it gets marked to market every Dec. 31, with that year’s paper gain or loss being treated as if it were 40% short-term and 60% long-term.
You can also buy put options on an ETF that owns a basket of stocks. The big ETF is the SPDR S&P 500 (ticker: SPY), and CBOE's options on it give you a lot of choices for expiration and strike price.
Do you aim for a near or a far away expiration? The near options have a lot of trading volume, so you won't give up much to market makers when you get in or out. The downside to short-term options is that you have to keep buying them. You end up spending a lot of money on crash insurance.
You might find the long-term options more affordable but their liquidity is lower. The same is true of options with strike prices that are way out of the money (that is, they pay off only in a big crash).
Own defensive stocks. GMO predicts that shares of companies with steady profits and strong balance sheets will hold up better than other stocks over the next seven years. In its institutional funds it owns
These companies have cash to burn and the first three of them pay dividends. But this defensive maneuver comes with no guarantees. Dividends won’t insulate you from a crash, and GMO may not even be right in its prediction that blue chips will outperform small companies.
Switch to bonds. An inflation-protected U.S. Treasury bond (a.k.a. TIPS) due in ten years has a yield of 0.6%. It could fluctuate in price in the meantime, but if you hold to maturity you will be assured of that 0.6% real annual return.
If you want to bet that inflation will stay low, buy a bond index fund instead. The Vanguard Total Bond Market ETF (ticker: BND) has a duration of 5.6 years, which means that it incurs about as much interest-rate risk as a zero-coupon bond due in 2019. At current inflation rates, the index fund’s 2.2% yield will give you a real return slightly better than the 0.6% on the ten-year TIPS. If inflation spikes upward, however, BND will hand you a negative real return.
