July 26th, 2023

Smart Hedging With Two Simple ETFs

We’re back again with our market multiple table and using that table to project where the S&P 500 could go and to build in protection, or hedging for portfolios in a ‘worst case scenario.’

If you’re worried about the market correcting, this is the simplest process you can use to protect your portfolio during short-term corrections without sacrificing income or gains.

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In yesterday’s issue, we built a market multiple table based on full-year earnings for the S&P 500 and projected the value of the S&P 500 based on what the market is willing to pay, ranging from 17x to 20x those earnings.

We considered three scenarios: Soft Landing (-5%), Current Expectations and Surprise Growth, which translated to $228 to $250 full year EPS for 2024.

We did not consider hard landing because it’s impossible to project what impact a severe recession would have on the market, and because, as of right now, no data suggests such a recession occurring.

We do have data suggesting soft landing in the form of the manufacturing sector which has been in contraction since December 2022. So that’s the rationale for building this the way I have.

Market Multiple Table: Red = Correction levels

Based on the table, and using only the current situation, we can project potential corrections to 4320 and 4080 on the S&P 500.

Those would equate to a -5.2% to -10.5% corrections from the current level of 4560.

When we then plot support lines on the S&P 500 chart, we find support at:

S1: 4400
S2: 4325
S3: 4260
S4: 4160

All four of which are contained within the 17-19x multiple range (4080-4560).

Given all of that information, how can you hedge or protect your portfolio from or against a potential correction?

Today and tomorrow, we’ll consider a few scenarios, from simple to advanced.

When hedging your portfolio, your goal is to offset short-term ‘value’ losses with gains. For example, if your stock portfolio is largely long-term buy and hold and the value of your portfolio is say $25,000, then you want to be able to protect against short-term declines in value of 5% to 10%.

What this does is protects you IN CASE you need to raise cash, or you decide you MUST sell shares of a stock.

For investors, the easiest way is to buy an inverse ETF where the goal is NOT a long-term buy and hold, but rather a short-term profit target.

Let’s look at two simple ETFs to target:

ProShares Short S&P 500 (SH)

This is a lower-cost ETF which investors with smaller portfolios or lower risk profiles can use to hedge their portfolios.

Currently trading around $13.65 (at the time of this writing), the chart shows the ETF at new lows, with future resistance levels at $14.50 and $15.

I would use no more than 5 to 10% of my total portfolio for capital allocation; so a $25,000 portfolio would set aside $1,250 to $2,500 to hedge their portfolio.

In this case, I would prefer to own 100 shares outright, or $1,365 invested at current prices.

This limits my capital in, and my risk in the position. It also gives me additional capital to either hedge with another ETF, or, to use as growth capital in a stock I really want to own that comes for sale during a correction.

Looking at the current chart, a correction in the S&P 500 should move the SH to $14-15 price levels, which would represent a 5% to 9.8% profit potential from current prices.

That’s good! Especially when considering corrections typically do not last long in this market environment.

And my time target for that would be 15-90 days from entry.

As an alternative, and to potentially juice returns, you could consider the ProShares UltraShort S&P500 (SDS)

A move from current prices (33.13) to future resistance would provide a potential 13.2% return.

I did not include options tactics on either of those ETFs because the options chains are too thinly traded, rendering them unusable.

So, tomorrow, we’ll look at how you can use options to hedge your portfolio…

John Hutchinson
Traders Reserve