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How To Get Defensive In Your Portfolio

Details on my process for shifting the portfolio to a defensive posture.

Although I've only been writing at TheMaven for about a month, I have made several references to the things I look for before taking defensive action in client portfolios. I had good luck during the financial crisis in terms of all three indicators going off pretty close to each other and that the behavior of the bear market rolling over slowly played out as normal, six months after the October 2007 peak the S&P 500 was only down 14%. My three indicators are the 2% rule, the S&P 500 going below its 200 day moving average and the inverted yield curve.

Because true bear markets start slowly they give plenty of time to get out which means you don't have to make drastic changes all at once. This is important because what might look like the start of a bear market may not be. Earlier in this bull market there were several instances where the SPX did breach its 200 day moving average but with no further consequence, retaking it a few days later. Selling one thing or just buying an inverse fund in that scenario simply creates a small drag, it doesn't result in getting whipsawed.

If you believe in defensive action in the face of a bear market, take action slowly, this is a crucial point of understanding. Crashes are a different matter, you are unlikely to avoid a crash and crashes, or fast declines, have the tendency to bounce back very quickly, the crash last week in bitcoin as the latest example.

So in terms then of trying to be out in front of the next time defensive action is called for the first thing that comes to mind is the tech sector. In terms of narrowed leadership in the market this year, that points directly to several of the tech mega caps like Facebook (FB), Microsoft (MSFT) and Apple (AAPL). The sector now weighs in at 24% of the S&P 500 which is more of a yellow light than the 30% weighting red light back in 2000. If there is excess anywhere in the market, tech might be the place.

Working with that for purposes of this post, most clients have had iShares US Technology (IYW) for a big chunk of their tech sector exposure combined with a some narrower exposures.

Although it depends on the client, as a rule of thumb I have about 10% in cash so I am net long about 90% as the market has gone up. Cash has built up from dividends and a couple of other things. I've been lucky performance wise thanks to some surprisingly strong gains by some names in the portfolio but having a little cash so late in the cycle makes sense to me and is a good starting point if the market starts to roll over. In trying to think about defensive action it would be ideal to protect a portfolio with as few trades as possible, maybe that will work out and maybe it won't, we'll see when we get there.

But as a starting point, if there is excess in the tech sector, then selling IYW which is at about an 11% portfolio weighting, quickly reduces net exposure to 79%. Clients already own the SPDR Gold Trust (GLD) and while there is no way to know whether the correlation will be negative in the next bear market it could be. GLD was up slightly in 2008 and ETFReplay shows the correlation to SPY as being negative for much of 2008 but not all of it. From there, 5% more could go into an inverse fund like ProShares Short S&P 500 (SH) which is a 1x inverse fund which brings the net long exposure now down between 70% and 75% with only two trades.

This would not be very disruptive to the portfolio and if it turned out to be a whipsaw clients would still participate with a move higher. If the market were actually doing down into something nasty then the position in SH would grow in relation to the portfolio thus hedging more of it as it went down if there were no more defensive trades placed. But as I said the idea is to start slowly and I think two trades in an equity portfolio of about 30 holdings is starting slowly. From there it might only take a couple of more trades to be defensively positioned for the worst of bear markets.

The most concise way I can express what I am trying to do is to look less like the stock market when it looks like a bear is starting. If you can avoid the full brunt of large declines you would be adding to long term performance. Also by saying avoiding the full brunt you are accepting that the portfolio will decline in value, hopefully less than the broad market. I don't think it is realistic to think you'll be up a few percent when the market cuts in half but I do believe it is possible to go down less with a disciplined approach.

This was just an example, things could look much different whenever the next bear market starts. However it does play out, I will share those trades here.