Smart Hedge™ – A Free Tool to Save Your Assets In a Bear Market
By Andrew Hecht, Chief Market Strategist
- What is the product?
- Why does it work?
- The performance
- No emotion
- The beauty of systematic trading
- The Smart Hedge™ market timing signals are free!
In an article published at the beginning of 2016 entitled The Top 10 Reasons Why The Stock Market Will Tank in 2016, we explained why U.S. equity markets are currently on very shaky ground. We wrote that article on Friday January 1st. Of course we had no way of knowing the S&P 500 would be down 6% and the Chinese would halt trading twice all in the first week of the year. We continue to believe 2016 will be a rough year for the stock market.
In treacherous markets, everyone can use a hand. In order to help investors weather the storm, Carden Capital has developed a free market timing tool, Smart Hedge™, which is available on the Carden Capital website. Smart Hedge™ generates returns on par with the S&P 500 with maximum losses that are less than half of the S&P 500. Smart Hedge™ will provide a compass for the dangers that are likely to confront markets as we plow forward into 2016. Right now, it is looking like 2016 will be both an election and a correction year in stock markets.
What is the product?
Carden Capital’s market timing product, Smart Hedge™, is a market timing algorithm. Carden Capital sends out Smart Hedge™ market timing signals and also publishes a Smart Hedge™ Index on its website so that people can see just how effective the strategy is over time. Interested parties can sign up for the free signals here. Unlike other market timing and commentary providers, which charge a lot of money for their service, but never actually show actual results or a back test, interested parties can get this signal for free, and can view the entire back tested results and summary statistics on the Carden Capital website. Carden Capital’s proprietary Smart Hedge™ Index demonstrates the results of a systematic S&P 500 Index market timing signal which is designed to participate in prolonged bull markets and avoid deep bear markets. On any given day, the Smart Hedge™ Index is either 100% long the S&P 500 Index or 100% in cash. In late 2015, the index reading was clear, stay in cash.
Carden Capital does not publish the methodology for the Smart Hedge™ Index. It is proprietary, but Carden Capital publishes both index values back to 1950 and real-time changes to index positioning. Depending on market conditions, the Smart Hedge™ Index dynamically switches between only two positions: 100% Cash or 100% long the S&P 500 Index.
Why does it work?
The index is systematic, meaning it uses the same methodology to determine when to switch between 100% cash and 100% S&P 500 Index allocation. The sample contains in excess of 100 changes in the allocation. Given the sample size, we can conclude certain inherent strength and weakness in the index. Overall, the Carden index produces about the same returns as the S&P 500 Index, excluding dividends, yes has maximum losses which are less than half of the index. The Index is long about 70% on all trading days and therefore produces about 70% of the dividend yield of the S&P 500 Index.
The index does a good job at letting investors enjoy prolonged bull markets while shielding investors from prolonged bear markets. You will notice the huge differences in performance between the index and the S&P 500 during years in which market shocks have occurred. In 1987, the S&P 500 was up 2% while the Smart Hedge™ Index gained 16.7%. In 2008 when the S&P 500 lost 38.5%, the Smart Hedge™ Index was flat on the year. These are just two examples of years in which the Carden index avoided downside market shocks.
While we do not want discuss the ‘secret sauce’ in detail publicly, what we can share is that the signals of the index are the result of different metrics of the price action of the S&P 500 Index. It very much ‘senses’ the long bias inherent in the equity market and applies a stop loss when the long bias likely fractures.
The reasons that we use ONLY S&P 500 Index price data are:
- Market price contains a substantial part of all relevant information to build this type of index
- Price data is available for decades; more sophisticated data outside of just the S&P 500 Index price to drive signals is of course available; however, historic data for information outside of price is often limited to significantly fewer years, which does not allow for such thorough back testing. Hence, the current index is a tradeoff between simplicity and decades of back tested index data.
The system is fully adaptive, meaning it can adjust to different market conditions dynamically. However, it works best in sustained bull or bear markets; in sideways-moving environments such as 2015, the performance trails the S&P index.
The index is prone to whipsawing, meaning in an environment such as 2015, where the S&P 500 Index did not make any clear directional commitments, the Smart Hedge™ Index will switch between 100% long S&P 500 Index and 100% Cash positioning, accumulating whipsaw losses. Overall, whipsaw losses are a common feature of this index. It many ways, it is has system characteristics that reflect a majority of small losing trades and a minority of big winning trades which make the entire process worthwhile. The index underperforms the S&P 500 Index on a regular basis UNTIL the S&P 500 Index experiences a major, prolonged correction. In total, the index beats the market in about 1/3 of the years, but in those years, it helps you avoid a bear market and major losses.
Therefore, followers of the index should expect a tradeoff: Regular underperformance during bull and sideways markets, significant outperformance during bear markets. The index does not predict the market. Instead, the Smart Hedge™ Index is a stop-loss tool. The index algorithm tries to long the S&P 500 Index whenever there is a good probability of a continuation of long bias inherent in equities. However, it will exit that exposure and move 100% into cash when a continuation of a recent downward movement is more likely than a reversal and a continuation to the upside.
Why does a stop-loss tool make sense? There is inherent long bias in equities, meaning millions of people working at those 500 companies included in the S&P 500 Index go to work every day trying to increase shareholder value. Macroeconomic expansion, over time creates an environment where stocks go up on average, not down. Additionally, the natural flow of buying from IRA and retirement programs means that the path of least resistance for stocks under normal conditions is higher. Therefore, from a long-term investment point of view (versus a short-term trading point of view), simply being long the stock market is a great idea. However, the 50%+ drawdowns the likes of which markets experience from time to time like in 2008/2009 cause not only distress but also panic and losses for many if not most market participants.
When using the index signal, it is important to keep in mind that when a signal occurs to move from 100% S&P 500 Index exposure to 100% cash. The signal does not mean the market is necessarily going to tank. What it means is that the market might go up, down or sideways; however, based on 65 years of historical index data, right now it is not worth the risk to remain in a long S&P 500 Index position. It is a stop-loss tool, a risk/return optimizer and NOT a market predictor.
As noted before, the Smart Hedge™ index makes approximately the same returns as the stock market over time, but it avoids major drawdowns, which are evident in the graph below.
One can see from the statistics that the returns are approximately equal over time yet the maximum drawdown is less than half of the index, leading to a substantially higher Sharpe Ratio.
There is a clear psychological angle to trading and investing. Two factors, fear and greed drive human emotions. These two issues are the reasons why the vast majority of traders and investors stop out of winning trades or stay in losing ones. The most profitable market participants have the ability to remove these two emotions from their approach to markets. Deeply ingrained in our psyches are these emotions. At times, fear and greed alone drive market action.
A discretionary trading program depends on the market professional to be one-step ahead of overall market fear and greed. Sometimes, this is simply too much to ask. A systematic trading program removes emotion from the decision making process, at all times.
The beauty of systematic trading
There are very successful non-systematic, i.e. ‘discretionary’ investors. However, the biggest issue with discretionary investing is that one can never truly determine if past performance of discretionary investors is mainly due to luck or skill.
Systematic investment models isolate certain circumstances in the market and then make a probabilistic bet. In other words, based on past and re-occurring patterns in the market, a systematic investment model positions capital for the greatest likelihood of returns eliminating emotion from the equation, at all times.
Systematic investment systems are unlikely to disappear in the future because if well designed, they exploit re-occurring patterns in the fundamentals of financial markets, which ultimately are reoccurring patterns in human behavior. Most such systematic models draw their roots from a field of finance called ‘behavioral finance.’ Therefore, a systematic model not only eliminates fear and greed it exploits the emotions for benefit.
Systematic investment systems eliminate emotions out of decision-making. However, they do not eliminate the emotions investors experience while following the model. These can range from euphoria if the model is outperforming the market to distress if the model is underperforming the market.
The Smart Hedge™ Market Timing Signals are Free!
Last week we wrote about the ten reasons that the S&P 500 will tank in 2016. We continue to believe that this is the case given the current level of the stock market combined with other factors influencing the direction of equity prices. The Smart Hedge™ Index first signaled excessive risk in the stock market on December 11 and the market has moved lower since. The S&P 500 Index closed at 2,012.37 on that day. On Friday, January 8, it closed at 1,922.03. As of the close of business on Friday, January 8, the index reading is to stay in cash. Since the beginning of 2016, Carden Capital’s Smart Hedge™ Index has outperformed the S&P 500 Index by 5.97%.