Doug Casey’s Crash-Proof Portfolio: How to Make Money When Stock Markets Crash

Via International Man

Editor’s Note: The below article is a classic piece written by Doug Casey. It’s timely and extremely relevant in today’s financial environment. We urge you to read what Doug has to say.

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It’s impossible to be sure, at any given moment, whether any market is going up or down. No matter how overpriced a market may be, there are always bulls with good-sounding arguments about why it could go twice as high. No matter how “cheap” a market may be, there are always convincing bearish arguments for it to go lower.

After all, for every buyer, there’s a seller (and vice versa). The same is true for the economy, where a case can be made for both good times and bad times at almost any juncture.

How can you hedge yourself against being on the wrong side of the market? By using “hedge” strategies which are surprisingly little-known, though they’re almost always lower-risk and have higher potential than pure long or short positions.

A “hedge” is a position where you buy X dollars’ worth of one stock or commodity and simultaneously short sell an equal dollar amount of a different stock or commodity. Since you’re both “long” and “short” the market, you don’t really care which way it goes. By choosing your positions intelligently, you can be right on both sides of your trade, regardless of overall market conditions.

As fashions change, the first tend to become last and the last become first. This was recognized in biblical times, and it’s equally certain in the investment markets. Regardless of the overall direction of the market, relatively overpriced stocks tend to decline and underpriced securities tend to rise. Indeed, both movements often happen at once.

By being both long one investment and simultaneously short another, you can escape the need to second-guess the direction of the overall market and still profit in either a bull or bear market. The keys to profitable hedging are patience and consistency: patience because it doesn’t make sense to be in any market all the time; consistency because your plan won’t work if you don’t follow it.

Most of the time, it’s a 50/50 bet whether something is going up or down, and you need better than 50/50 odds to make money. The idea is to be in a given investment only when the odds of it going up appear to be 90% or better and to be short when the odds of it going down are equally strong. It is fortunate that odds that strong usually identify investments that are getting ready to move 10 for one or more as well.

Suppose, for instance, you like the prospects of Stock X. You’re sure the underlying company will do well. But you’re afraid of the market as a whole, which could take Stock X down despite the company prospering. How do you solve the dilemma of whether to buy or to wait?

A hedge might be the answer. Find another company in the same industry, Stock Z, which you feel has terrible prospects and perhaps will lose business because of Company X’s success and whose stock looks to be overpriced. Then, buy Stock X and short an equal dollar amount of Stock Z.

If your assessment is correct, it will not make any difference how the market in general, or the industry in particular, does. You’ll make money as long as X does better than Z—whether they both go up or they both go down. And, if their prices move in opposite directions, you can make money on both and double your profits, even while you’ve reduced your risk.

Value is relative, not absolute. In other words, you want a position not only because of what it is, but because of what price it is.

It’s never a question of how many dollars you can get for something you want to sell. The real question is how many shares, or contracts, or acres, you can exchange it for. It might, for instance, be hard to say whether corn is cheap or dear at, say, $4 a bushel unless you know what to compare it with. But we know that wheat usually sells for about twice the price of corn and soybeans for about triple—because of factors like production costs and protein content. If soybeans sell for $6 while corn is at $4, you can be pretty sure corn is dear, at least relative to beans. By selling corn and buying beans, you’re likely to make money.

The idea is to pick out very cheap stocks or commodities to buy, and very dear ones to sell simultaneously, with the intention of protecting yourself from general market moves. Buy and sell respectively equal dollar amounts of each and wait for the inevitable without caring whether the market in general booms or busts.

An Example

In 1991, I recommended such a hedge in the thrift industry. It provides an ideal illustration of the principle.

Continental Federal, a savings and loan bank based close to Washington, D.C., was selling for $5—less than a fourth of its $22 book value, and about a fifth of its previous high of $27. An analysis of its balance sheet showed it could even then have been liquidated for $15. It exceeded all regulatory capital requirements by at least two to one. All but a few of its loans were in the relatively low-risk residential market, and it had already charged off most of its bad loans.

Although management had been competent in making good loans, their overhead expenses were very high at 320 basis points of their $1.1 billion of assets (i.e., about $35 million or 3.2% of assets).

Typically, for a public company, management was treating themselves quite well at shareholders’ expense. Why? They owned only 100,000 of the 2.9 million shares outstanding. Overhead should be no more than 250 basis points (2.5% of assets), and a difference of 70 points on $1.1 billion is about $8 million per year. If management were forced to tighten their belts by only that much, the stock could easily sell for at least $12 per share.

A group of shareholders, including myself, joined together to make it happen. Still, because of my misgivings about the economy at large, I did not want to be long Continental Federal without being short an equal dollar amount of something likely to join the choir invisible. GlenFed, the third-largest thrift in the United States, with most of its assets in California, seemed like a good choice in that category.

GlenFed had about $16.5 billion in assets and $950 million in stated capital, which was satisfactory on the surface. But about 80% of its capital was debt, on which the interest clock continued to run. At the same time, almost any portfolio losses could quickly wipe out shareholders’ equity since non-performing assets were already over $700 million, and in California’s depressed real estate market, it was clear they could easily suffer large losses.

In addition, GlenFed owned numerous hotels, shopping centers, and business parks through a subsidiary, the very worst things to be in at the time. It was all for sale, but there were no bidders because it seemed likely that the Resolution Trust was going to wind up with GlenFed’s properties and potential buyers could get them more cheaply later.

The hedge worked out well. GlenFed crashed 80%, from $5 to $1, while Continental rose to $22, where it was bought out by Crestar Bank. I wound up making more money using a hedge than I would have simply being right about Continental—and I took much less risk, to boot.

As longtime readers know, I think we’re just now exiting the eye of the giant financial hurricane that we entered in 2007, and we’re going into its trailing edge. It’s going to be much more severe, different, and longer-lasting than what we saw in 2008 and 2009. For reasons I’ve explained elsewhere, we’re headed for an economic disaster that in many ways will dwarf the Great Depression of 1929–1946.

Given this bearish outlook, most U.S. stocks are likely to be money-losers in the coming years. Although most financial advisers would gasp at the notion, it’s a perfectly reasonable strategy to avoid owning U.S. stocks today.

Instead of owning U.S. stocks, conservative investors who don’t want to spend much time managing their portfolios can keep a 50/50 allocation of cash and gold. This is a conservative allocation that will hold up well during tough times. It might not make you a lot of money in the coming years (although it could if gold soars), but it certainly won’t make you lose much either.

However, if you’d like to own U.S. stocks, consider hedging your holdings using the strategy I’ve described. I don’t mean hedging just a few of your stocks by pairing them with short positions. I mean hedging your entire portfolio of stocks.

Here’s how. Take a look at your present holdings. Identify those positions in the most inflated industries and those unlikely to survive a financial collapse. Sell off the most overpriced half of these, then take that cash and use it to short issues that are wildly expensive or buried in debt or run by people of bad character.

By taking these steps, you’ll make your stock portfolio “market neutral.” A portfolio is market neutral when it doesn’t have a bias toward higher or lower prices. It’s a portfolio with an equal amount of long positions (that profit when prices rise) and short positions (that profit when prices fall).

If you have $30,000 invested in positions that profit when prices rise and $30,000 invested in positions that profit when prices fall, you have a market-neutral portfolio.

With a market-neutral portfolio, you don’t have to rely on the market going up to profit. And if you select your longs and shorts well, you’ll make money even when stocks crash. If your portfolio is market-neutral, you need not worry if the broad stock market rises or falls. To make money, you only need the assets you buy to perform better than the assets you sell short.

Let’s go over an example…

Say you buy $10,000 worth of Lockheed Martin (LMT)—a bet on more foreign wars and adventures—and sell short $10,000 worth of Bank of America (BAC)—a bet on financial chaos… If Lockheed Martin climbs 10% and Bank of America falls 10%, you make $2,000. (That’s 10%, or $1,000, on each $10,000 position.)

If Lockheed Martin climbs 10% and Bank of America also climbs 5%, you make $500. (That’s a $1,000 gain on Lockheed Martin and a $500 loss on the Bank of America short position.)

And if Lockheed Martin drops 10% but Bank of America also drops 15%, you also make $500. (That’s a $1,000 loss on Lockheed Martin and a $1,500 gain on Bank of America.)

The only way you lose on this market-neutral position trade (often called a “pairs trade”) is if Bank of America outperforms Lockheed Martin.

Although I think most industries will struggle in the bad times ahead, a handful of industries could actually do quite well. Whatever you choose to do, the most important thing to keep in mind is this:

You’re very unlikely to do well with a conventional “long only” portfolio in the coming years. Again, conservative investors can keep a 50/50 allocation of cash and gold. This is a defensive strategy that should protect you from losing much money.

Not losing money is a worthy goal. In a bear market, the guy who wins is the guy who loses the least. He’s the guy who has cash at the bottom. He’s the guy who buys assets from desperate sellers. He’s also the guy who ends up owning the best assets.

But if you’re an experienced investor with time to spend managing your portfolio, you could do very well with a market-neutral portfolio.

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