Stock market hedging as we know it is broken — but there

REUTERS/Carlo Allegri

• 
  Hedging methods that have worked for years have broken
  down, leaving investors wondering how they can protect their
  hard-earned gains from a market meltdown.
  


• 
  Fear not, for there are hedging solutions that go
  beyond the traditional practices of simply buying US Treasurys
  and the dollar as protection.
  

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Hedging isn't as easy as it
used to be.

Until recently, an investor looking to protect against
stock declines could simply purchase long-term Treasurys or US dollar futures, the
logic being that the assets traded inversely to one another. If
stocks went up, the other assets would go down, and vice
versa.

But that relationship has broken down, derailing the
strategy and
leaving investors wondering how they
can protect their hard-earned gains from a market
meltdown.

The chart below, from financial services firm INTL FCStone, shows this dynamic in
action. It highlights how negative correlations between stocks
and both the dollar and Treasurys have risen and gotten closer to
zero, or, in the case of the dollar index, even become positive —
suggesting a decline in hedging efficacy.

INTL
FCStone

"The correlation between the US dollar index and stocks has
already flipped, and long-term treasuries are no longer a perfect
hedge against stock market volatility," 
INTL
FCStone macro strategist Vincent Deluard wrote in a
recent client note. "This change has gone largely
unnoticed."

But why? How could investors be so blind to such a drastic
market shift?

Deluard notes that when stocks are going up everyday,
investors eschew hedging activity. And equities have certainly
soared in recent months, hitting a seemingly endless streak of
new record highs, lulling traders into a dangerous sense of
complacency.

So with this all established, what's the way forward for
investors who want to hedge, but can't go their normal
route?

Deluard breaks down what he sees as the three best
possibilities:

• Buy equity put options that are attractively priced at
  the moment — Deluard notes, however, that
  this is an incomplete hedge, since it only protects against
  losses in stocks, not bonds or the dollar.
  


• Find a new "risk-off" asset to buy when things get
  rough — Deluard recommends gold, the
  Japanese yen, and the Swiss franc as ideal candidates to
  replace Treasurys and the dollar.
  


• Buy high-quality floating rate corporate bonds and
  long-dated oil futures — Deluard says that
  these protect against the two biggest risks of 2018: rising
  rates and inflation.
  

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