8 Hedging Strategies for a Potential Stock Market Correction

Stay afloat during a market correction.

The recent sell-offs in the stock market and lower bond yields could be indicators of a potential correction as many businesses struggle to stay afloat while the impact of the global pandemic lingers. The tech-focused Nasdaq has already been in correction territory for several weeks, and the S&P 500 reached a 10% correction in September. Declines in both benchmarks could be indicators of a larger decline and/or increased volatility. Investors may want to consider diversifying or reallocating their portfolio. While investors may have “ridden the wave of this unprecedented market recovery, even the most risk-averse portfolios likely can’t escape inevitable bouts of volatility,” says Rick Swope, senior director of investor education at E-Trade, a brokerage company. “Market fluctuations are par for the course when it comes to investing.” Here are eight hedging strategies to consider.

Gold

Gold has the lowest correlation to stocks. In the past 10 years, on average, for every 1% decline in the S&P 500, both physical gold and gold futures increased 0.2% as of Aug. 31. Gold is a good asset to diversify a portfolio and does not always rise or fall with bonds, says Michael Underhill, chief investment officer at Capital Innovations in Pewaukee, Wisconsin. “Numerous studies show that gold proves superior to general commodity exposure in portfolio construction to deal with market corrections or bear markets in Treasurys, equities and the dollar and also when real interest rates are negative,” he says. Investors can hedge against a bear market by adding precious metal stocks (even through exchange-traded funds), says Ron McCoy, CEO of Freedom Capital Advisors, who is overweight on the VanEck Vectors Gold Miners ETF (ticker: GDX), Newmont Corp. (NEM), Barrick Gold Corp. (GOLD) and Yamana Gold (AUY). “Timing the market is never easy, but owning some gold in one’s portfolio should make some sense given the huge deficits that are going to continue for at least the foreseeable future,” he says.

Cash

Interest rates for certificates of deposit are extremely low: A 12-month and three-year CD both yield 0.75%, while a five-year CD yields 1% at Ally Bank. Cash and Treasury bonds have historically shown low correlations to equities, says Kristina Hooper, chief global market strategist at investment management company Invesco. “Cash offers low volatility, which makes it attractive,” she says. “One drawback is if inflation were to rise, it could erode its value over time.” One strategy to lower your risk profile is by moving to cash and cash equivalents, like short-term fixed income, says Steve Sosnick, chief strategist at Interactive Brokers. “Many investors fear a capital gains tax increase if there is a blue wave, so selling stocks now could have tax benefits later down the road,” he says.

Treasurys

Treasury bonds are also seen as a defensive asset class, but they can be far more volatile than cash, Hooper says. They also can be negatively impacted by higher inflation, she adds. Owning Treasury Inflation-Protected Securities, or TIPS, can help investors with inflationary concerns and are up by 17% from their lows of 2018, says Daren Blonski, managing principal of Sonoma Wealth Advisors. “There can be less volatility in TIPS,” he says. “Slow and steady can win the investment race, too. If you think we are likely to see inflation in the near future, TIPS can offer some growth with less volatility and stock market risk.”

Bonds

Investing in short-term bonds means investors have minimal correlation to the stock market and receive yields that are higher than what cash provides, Blonski says. The JPMorgan Ultra-Short Income ETF (JPST) is an actively managed ETF that invests in investment-grade, U.S. dollar-denominated fixed, variable and floating-rate debt of corporate and bank bonds with a duration of one year or less. JPST has a one-year return of 2.48% and three-year return of 2.55% as of Sept. 28, with an expense ratio of 0.18%. JPST performed well after the Great Recession and the market downturn in mid-March. “You are taking on minimal risk for some yield,” he says. “This is a slightly better alternative than cash.”

Silver

Silver can also serve as a way to diversify a portfolio since it is weakly correlated to bonds and stocks, says Jodie Gunzberg, managing director, chief investment strategist at Morgan Stanley, Wealth Management Institutional. Silver has a correlation of 0.3 to the S&P 500 and 0.23 to the Bloomberg Barclays US Aggregate Bond Index. Since silver has more industrial uses, its price moves more with inflation and the U.S. dollar compared with gold, she says. Silver could be a good buy if investors believe the U.S. dollar will continue to dip, Blonski says. Spot prices for silver have been very volatile historically, and investors “have to be ready for the ride since the moves in prices are exaggerated,” he adds.

Stocks

Investors who want to have an allocation to equities can consider the S&P 500 Utilities Index, which has a low downside capture ratio of 15.3, Gunzberg says. Utility stocks decline with the broad market, but only 0.15% for every 1% drop on average in the S&P 500. “There may be some good buying opportunities within equities with the volatility if the market pulls back,” she says. “Look to cyclicals over defensives, non-U.S. stocks and sectors that are geared for an economic recovery and levered to rising rates.” Investors who have cash sitting on the sidelines will find that “now is a great time to be selectively picking up laggard stocks in the financials, industrials, materials and small pockets of energy that will outperform in the early part of the new cycle,” says Thomas Hayes, chairman of Great Hill Capital in New York. Gross domestic product growth of about 6% will occur in 2021 due to the magnitude of the response to the short-term contraction, he says. “This is when cyclicals have relative outperformance and S&P earnings estimates for 2021 support this thesis: energy, consumer discretionary, financials and materials will all grow faster than the S&P 500.”

Options

Investors can utilize options as a hedge, Swope says. Put options give investors the right to sell a stock or ETF at a specific price during a specific time period and can protect positions if there’s a decline. “Investors buy a protective put with a strike price that is below the current stock price but where they’d be willing to sell the stock if it were to decline,” he says. “An investor can sell the stock at that strike price regardless of how much lower it goes, essentially capping losses.” Investors may also want to add option credit strategies for adding income to a portfolio. They could buy and sell combinations of puts and/or calls to create a spread that generates immediate income and has the potential to profit if the stock moves in the expected direction, Swope says.

Commodities

Investors could find tremendous opportunities in agriculture and precious metals since they are uncorrelated to stocks, says David Martin, chief investment officer of Martin Fund Management in New York. He predicts there will be an “impending crisis” in food items like corn and soybeans as well as commodities like coffee, sugar and cocoa. These commodities are at or near their 30-year lows and are predicted to rise as China is ramping up purchases of soybeans and corn. “A lot of people are hurting because their incomes are being slashed, and food prices are increasing,” he says. “There could be a humanitarian food crisis.” Investors could add an ETF such as VanEck Vectors Agribusiness ETF (MOO), which comes with a one-year return of 4.41%, three-year return of 6.39% and five-year return of 10.52%. MOO’s dividend yield is 1.51%, and its expense ratio is 0.56%.

Eight hedging strategies to consider:

— Gold

— Cash

— Treasurys

— Bonds

— Silver

— Stocks

— Options

— Commodities

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8 Hedging Strategies for a Potential Stock Market Correction originally appeared on usnews.com

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