The inflation monster is coming for your money — how do you fight?

Link to original article: Aviator Research Newsletter: Inflation Hedges for your portfolio

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Summary:

• Markets are jittery, and the prime culprit: fears of high / persistent inflation — which really isn’t good news for stock prices.
• Now, there’s no reason to believe the inflation we’re seeing today is persistent or worryingly high — but it is important to protect your portfolio against the risk.
• There are ways to protect your portfolio while staying invested. Conventional hedges include adding gold, TIPS and more ‘inflation resistant’ (details below) stocks to your portfolio.
• My favorite hedge / protection strategy though: PUT options on ARKK ETF (or equivalent high-growth stock ETFs). Best of all, you can hedge your entire portfolio with less than 5% of your capital, while keeping the rest invested. (Strategy not recommended though if you don’t understand how options work and the risks involved).
• It’s important to remember, hedges are like an insurance policy — designed for downside protection, not for making profits. Also important to note that the PUT option strategy is a short term strategy till there’s more clarity on the direction of inflation.
• More details including sizing your hedges / protection shared below

Hello Aviators,

The economy is booming. Consumer spending is sky rocketing. And yet, stock markets have been jittery since February, and especially so in the last few weeks. Why?

One word: INFLATION

Source: https://www.cagle.com/brian-adcock/2011/10/inflation-monster

As an investor, inflation is the number one risk to your portfolio today (assuming you’re diversified enough to protect against company / industry specific risks). And so in this edition of the newsletter, we’ll discuss Aviator Research’s perspective on understanding and protecting your portfolio from this monster. We’ll hit on:

• How does inflation affect stock prices?
• Are the current fears of inflation justified?
• Some approaches to protect your portfolio against inflation (and the associated market risks) — feel free to jump straight ahead to this section if you want to skip the economics primer and get right down to business
• And finally, impact of the hedge on the Aviator Research portfolio

How does inflation affect stock prices?

Unfortunately, not too well. Inflation shrinks the purchasing power of money — i.e., a dollar today is worth less tomorrow.

Source: WSJ

Stocks — like most cash generating assets — are valued on its future expected cashflows. If those future cashflows are worth a lot less due to inflation, then the stock price too goes down.

Additionally, central banks tend to increase interest rates to combat inflation. Higher interest rates = higher borrowing costs for companies = lower investments in growth. Rising input prices and wages can also hurt a company’s bottomline. Not to mention, with higher interest rates, investors demand greater return on their assets (which by extension tends to depress prices).

This is not to say all stocks will be beaten down by high inflation. A high cashflow generating business, with low inflation impact on input costs, and pricing power is likely to be impacted a lot less than companies valued primarily on high growth in future cashflows / facing much higher input costs / having low pricing power to pass on to consumers. Some sectors may also do better than the others (e.g., banks may do well in moderately high inflation environments due to interest rate increases). But by and large, high inflation is not good news for stock prices.

Takeaway: Stock prices broadly tend to not do too well when inflation fears increase / persist.

So, are current inflation fears justified?

Leading economists are torn on this. And I’m not an economist — my guess is as good as yours.

But let’s look at some facts. In April, headline inflation jumped to 4.2% — the largest jump since September 2008 (and for some context, inflation averaged 1.7% in the last decade).

Before you panic though, partly, this is to be expected:

• There is pent-up demand and high consumer savings coming out of the pandemic being unleashed now as a result of economies reopening. Add to that the additional spending power from stimulus checks and record low interest rates.
• On the supply side, businesses slashed capital spending and inventories, expecting a recession due to the pandemic — and are now scrambling to catch up to demand.
• Economics 101 teaches us that when demand rises and supply is constrained, prices rise. However, as supply side constraints loosen up and demand cools after the initial burst, prices are likely to moderate.

Let’s also dive a little closer into the inflation numbers:

Source: US Inflation Calculator (US monthly inflation data)

As you can see from above, the inflation rates from April — July 2020 were well below average (and stayed below average through the rest of the year). And inflation is calculated on 12-month prior base (e.g., April 2021 inflation is calculated as the increase on April 2020 price base). Thus, even though the sudden jump to 4.2% looks worrisome, if say April 2020 price rise was close to the typical ~2%, April 2021 inflation would have been ~2.4% — above average, but not worrisome.

Given the extremely low base from April to July 2020, I expect inflation rates to stay high through the corresponding period in 2021. What we should be worried about is further spikes in inflation rates, or high inflation rates persisting beyond say August.

And finally, millennial investors’ favorite portfolio manager and CEO of Ark Invest, Cathie Wood thinks that the big long term risk is not inflation, but deflation — and mostly the ‘good kind’ — driven by lowering cost of production / distribution as a result of innovation. Granted, as a fund manager that invests in hyper growth companies, she has an incentive to downplay inflation fears. But her point still holds merit.

Source: Business Insider

Takeaway: While inflation rates are rising, there is no reason to believe that this is a persistent shift (which is the kind investors are / should be worried about).

That however doesn’t mean you shouldn’t protect your portfolio against it. Here’s why:

1. I don’t think anyone knows whether the inflation we’re seeing today is transitory or persistent — best to prepare for the worst.
2. Even if inflation proves transitory, markets can get spooked in the interim, putting a significant dent to your portfolio.

In the next section, we’ll discuss a few ways you can protect your portfolio against this risk.

All that’s great — but how can I protect my portfolio?

One approach — and a perfectly valid one — is to pull your money out of the market. When I’m tempted to do that though, I remember this quote from legendary mutual fund manager Peter Lynch:

Nevertheless, in this time of uncertainty, it is not a bad idea to take out any money you cannot afford to lose from the markets (in fact, this holds irrespective of market conditions).

It’s also important to remember that cash is not a great place to be in times of inflation — because by definition, inflation will chip away at the value of cash. So what are the alternatives?

Before diving into my preferred inflation hedge strategy, let’s go through a few usual suspects (feel free to skip straight ahead to the ‘preferred hedge’ if you’re in a hurry):

• Bitcoin (not so good): Bitcoin — with its decentralized control and supply constraints seemed to be the perfect hedge against inflation and loose monetary policy. However, that thesis hasn’t played out yet — in fact, it’s been one of the worst performing asset classes during this time of uncertainty (probably due to reasons outside of inflation worries). Hence, while in the long term Bitcoin may or may not be a good inflation hedge, for now it’s a hard pass.
• Commodities (no perspective): No perspective here since I don’t understand this asset class as well. My very basic understanding seems to suggest that as a broad class, commodity prices may have already peaked (due to the sudden supply-demand mismatch), and may not have much more room to run up further. Additionally, if you’re considering getting exposure to commodities through commodity ETFs, most are not based on actual holdings, but are constructed through futures. That brings with it a whole other set of risks (e.g., contango effect) outside of commodity prices alone.
• Gold (not bad, but hit or miss): Gold — another commodity — is traditionally considered a strong hedge against inflation. While it’s not a bad hedge against inflation and economic uncertainty, the relationship is also not as tight as one would expect. Additionally, when stock markets take a hit, it’s also not uncommon for gold prices to take a hit, atleast in the short term. All said and done though, gold is still a decent hedge and worth adding to your portfolio (but not much — less than 5%). Gold ETFs (like IAU) also have the added advantage over most other commodities in that that are pegged to the spot price and are not based on futures (which as I mentioned, brings a whole added set of complexities even if the underlying commodity price is expected to do well).
• Treasury Inflation Protected securities / TIPS (better): These securities are designed to keep up with inflation — and as a result will provide some inflation hedge. However, it’s important to keep in mind that some inflation is already priced in today — as you can see below, they’re trading at negative yields (returns) today (~-0.8% for a 10Y TIPS). Basically, that means buyers are willing to pay the government in order to get future inflation protection.

Source: FRED

• Nevertheless, it’s not a bad idea to have some TIPS in your portfolio. While it will not protect you from ‘expected’ inflation, it will provide protection against an unexpected increase in inflation (which is really the worry factor anyway). You can get exposure to TIPS through ETFs like TIP (iShares TIPS bond ETF).
• ‘Inflation resistant’ stocks (not bad): Like I mentioned earlier, some stocks tend to do better than others during inflationary periods — I’ll refer to them here as ‘inflation resistant’ stocks. Companies with strong cash-flows, valued at reasonable multiples (of cashflows / profits), and enjoying pricing power / low input costs are generally a better bet than companies largely valued based on future expectations of growth. Similarly, some sectors (e.g., banking, apartment REITs) tend to do better in higher interest rate environments (interest rates are typically hiked in inflationary periods). While these stocks may still take a hit if the broader market turns bearish, impact on them is likely to be less pronounced.

Now for my preferred portfolio hedge against inflation risk: PUT options on ARKK (or another equivalent high-growth focused ETF).

Before I go any further, I do want to highlight that this is a derivatives based strategy — and comes with significant risks. If you do not know how options work or the risks involved, I suggest you do not try this (subsequent content on this strategy below will assume you have a working knowledge of options). For most investors, adding a mix of inflation resistant stocks, gold and TIPS to your portfolio should suffice to provide some hedge against inflation. Also important to note that the PUT strategy is more of a short term strategy (for the next 3–6 months) until there’s more clarity on the ‘persistence’ of inflation.

Okay, now back to PUT options on ARKK (ARKK is the flagship ETF of ARK Invest).

Rationale for the strategy: Like we’ve discussed before, inflation eats away at the value of future earnings / cashflows. Thus, companies valued based on aggressive growth expectations are likely to suffer the most as a result of rising / persistent inflation. And ARKK is one of the best known ETFs focused on companies that are primed for exponential growth — hence, betting against it (i.e., purchasing PUT options) seems to be a reasonable strategy to protect against inflation. Additionally, ARKK’s performance correlates very well with market performance — hence a bet against it would theoretically provide a solid hedge against market downturns.

It may seem surprising that I’ve quoted ARK Invest’s Cathie Wood earlier, and now am betting against her ETF. This has nothing to do with Cathie Wood’s ability as a portfolio manager (she’s probably one of the world’s best). Instead, it’s a simple exercise in logic: ARKK has positioned its portfolio with the idea that inflation isn’t a major risk. So if fears of high / persistent inflation do come true, it’s likely that ARKK will not perform too well — and hence the bet against it to protect against inflation.

Which PUT options to buy: I don’t have a good answer here. Will share some personal preferences — but if you’re an experienced options trader, I’m sure you can find better ways to structure it. I generally prefer to buy options at least 6 months out to minimize time decay, and then roll it over every month of so. In this case, I also prefer to buy deep out of money options — my objective is not for this to provide protection against minor market corrections, but to really kick in if / when there is a sizable correction.

How much to buy: This depends on many factors including how much protection you want, the strike price / expiry date of the options etc. With that said, I wouldn’t recommend buying more than 1% — 3% of your portfolio (and almost definitely not more than 5%). Remember, this is an insurance policy designed to protect the rest of your portfolio, and not a strategy designed to make investment profits. Hence, you should be comfortable letting your ‘insurance’ expire worthless.

Let’s run some calculations to see how the hedge would work in practice (can get a little technical — it’s not complicated though. However, feel free to skip straight to the portfolio allocation at the bottom if this isn’t your cup of tea):

Let’s assume that you buy $81.96 PUT options on ARKK expiring in Jan 2022, with 3% of your portfolio. The current price per option is $5.55 (or $555 per contract). Now, we’ll go through a few scenarios to test how our hedge would work (the numbers below are high-level swags to get a rough estimate). For our analysis purposes, we’ll assume that your portfolio mimics the performance of S&P 500.

Scenario 1: S&P 500 goes down by 10%

Impact on your portfolio without hedging: Down by 10%

Impact on your portfolio (with hedging):

• Your main portfolio (excluding ARKK PUTs): Down by 9.8% (98% of your portfolio goes down by 10%)
• ARKK has a beta of ~1.5 — so let’s assume ARKK goes down by 15% in the same situation; i.e., it’s down to $90 from the current $106 (i.e., down by $16)
• In this situation, we can expect the ARKK PUT options to trade at ~$11.10 (the price of $97.96 PUT when stock price is at $106 — which is $16 more than the $81.96 PUT, since that’s the rough equivalent PUT when stock price drops to $90)
• At $11.1, it’s a ~100% increase over original price of $5.55. Thus, overall impact of ARKK PUTs on the portfolio: 100% x 3% (allocation) = 3% up
• Net impact on portfolio with hedging: -9.8% + 3% = -6.8%
• Thus, instead of losing 10%, your portfolio only lost ~7% as a result of the hedge. In practice, you’ll probably lose a little more since the options will decay in value as well over time.

Scenario 2: S&P 500 goes down by 20%

Impact on your portfolio without hedging: Down by 20%

Impact on your portfolio (with hedging):

• Your main portfolio (excluding ARKK PUTs): Down by 19.6% (98% of your portfolio goes down by 20%)
• ARKK has a beta of ~1.5 — so let’s assume ARKK goes down by 30% in the same situation; i.e., it’s down to $74 from the current $106 (i.e., down by $32)
• In this situation, we can expect the ARKK PUT options to trade at ~$19.5 (the price of $113.96 PUT when stock price is at $106 — which is $32 more than the $81.96 PUT, since that’s the rough equivalent PUT when stock price drops to $90)
• At $19.5, it’s a ~250% increase over original price of $5.55. Thus, overall impact of ARKK PUTs on the portfolio: 250% x 3% (allocation) = 7.5% up
• Net impact on portfolio with hedging: -19.6% + 7.5% = -12.1%
• Thus, instead of losing 20%, your portfolio only lost ~12% as a result of the hedge. While that’s still a lot to lose, it’s a lot better than without hedging. The other thing you’ll notice is that as the market loses more, due to the leverage built into options, your hedge will cover more of your losses.

Now, let’s look at scenarios where the market goes up.

Scenario 3: S&P 500 goes up by 10%

Impact on your portfolio without hedging: Up by 10%

Impact on your portfolio (with hedging):

• Your main portfolio (excluding ARKK PUTs): Up by 9.8% (98% of your portfolio goes up by 10%)
• ARKK has a beta of ~1.5 — so let’s assume ARKK goes up by 15% in the same situation; i.e., it’s up to $122 from the current $106 (i.e., up by $16)
• In this situation, we can expect the ARKK PUT options to trade at ~$2.6 (the price of $65.96 PUT when stock price is at $106 — which is $16 less than the $81.96 PUT, since that’s the rough equivalent PUT when stock price increases to $122)
• At $2.6, it’s a ~50% decrease over original price of $5.55. Thus, overall impact of ARKK PUTs on the portfolio: -50% x 3% (allocation) = -1.5% down
• Net impact on portfolio with hedging: 9.8% — 1.5% = 8.3%
• Thus, instead of making 10% gain, your portfolio only made a gain of 8.3%. That’s the downside of hedging — when market moves in the direction you want it to, your hedge drags the portfolio performance down. After all, there’s no free lunch!

Scenario 4: S&P 500 goes up by 20%

Impact on your portfolio without hedging: Up by 20%

Impact on your portfolio (with hedging):

• Your main portfolio (excluding ARKK PUTs): Up by 19.6% (98% of your portfolio goes up by 20%)
• ARKK has a beta of ~1.5 — so let’s assume ARKK goes up by 30% in the same situation; i.e., it’s up to $138 from the current $106 (i.e., up by $32)
• In this situation, we can expect the ARKK PUT options to trade at ~$1.1 (the price of $49.96 PUT when stock price is at $106 — which is $32 less than the $81.96 PUT, since that’s the rough equivalent PUT when stock price increases to $138)
• At $1.1, it’s an ~80% decrease over original price of $5.55. Thus, overall impact of ARKK PUTs on the portfolio: -80% x 3% (allocation) = ~2.5% down
• Net impact on portfolio with hedging: 20% — 2.5% = 17.5%
• Thus, instead of gaining 20%, your portfolio made only 17.5%. Again, no free lunch remember. But the upside here: Even though you lost almost the entire amount you set aside for the hedge, you still made a good return overall. And you cannot lose more than the total amount you invested in the hedge (i.e., 3%). But a good reminder that it’s important to only hedge with an amount you’re willing to lose (for me, that threshold is ~5%).

Summary of returns for the various scenarios (and added a 5% hedged portfolio scenario as well for comparison):

As you can see,

• The hedge reduces downside risks, but also reduces the upside marginally. And larger the hedge size, the more pronounced the impact.
• And the larger the market drops, the more ground the hedge covers in covering losses due to the leverage in options.

The above are illustrative scenarios to give you a sense for how the hedge would work. In practice, the results would likely be different (and ofcourse would very much be dependent on the options you purchase / the size of your hedging position).

Impact of the hedge on the Aviator Research portfolio

Aviator Research portfolio has decided to go with a 3% hedge using the same PUT options discussed in the scenario (ARKK Jan 2022 PUT @ $81.96 strike). Chose 3% because this is still an experimental strategy and not willing to risk more than that,

Here’s the updated portfolio:

Reduced from TPR and allocated to the ARKK PUT option hedge. TPR chosen only because my confidence in that bet didn’t warrant as high a position in the portfolio as it earlier did.