The Global Guru: Why this is a Very Strange Market… and My “Hedge Portfolio”

Nicholas Vardy

Nicholas Vardy has a unique background that has proven his knack for making money in different markets around the world.

It is strange time in global financial markets — stranger than most investors realize.

On the one hand, the U.S. market is trading near record highs, with the S&P 500 hitting a new record last week. The Japanese stock market is soaring, thanks to “Abenomics” and the Bank of Japan’s historically unprecedented commitment to quantitative easing.

On the other, few other stock markets or asset classes in the world are participating in the rally. After a strong start to the year, European stocks have given back their January gains. And the rally in “risk on” assets in emerging markets that I expected in January never materialized.

In the past, I’ve always recommended that my Alpha Investor Letter subscribers look at my “hedge portfolio” to protect themselves from tumbling financial markets.

Yet, in a “risk-on” environment where the world’s two largest stock markets, the United States and Japan, are rising strongly, the “risk-off“ strategy of the hedge portfolio is also performing surprisingly strongly so far in 2013.

What is the “Hedge Portfolio”?

The hedge portfolio’s objective is to assemble a set of assets — using specialist exchange-traded funds (ETFs) — that make money when financial markets fall out of bed.

The hedge portfolio places bets on or against a wide range of assets, including the stock market, commodities and currencies.

Broadly speaking, you can expect the ETFs in this portfolio to go up when financial markets go down.

1) Short MSCI Emerging Markets (EUM)

For all of the talk about how emerging markets are set to dominate our economic future, they are always the first asset class to collapse when markets revert back to “risk-on” mode.

This year, the behavior of emerging markets has been perplexing. After all, global stock markets aren’t really in a “risk on” mode.

Yet, confounding the predictions of almost all the smart money out there, emerging markets have been a lousy performer so far in 2013.

Scratch the surface, and you see that much of this weak performance is due to the under-performing BRIC stock markets of Brazil, Russia, India and China. (I touched on a handful of exceptions in emerging markets in last week’s edition of The Global Guru.)

The best way to profit from tumbling emerging markets is through the Short MSCI Emerging Markets (EUM). This ETF is the inverse of the MCSI Emerging Market Index. The fund is designed to profit when the index goes down.

This position is up 5.56% since Jan. 1, not far off the positive returns of the U.S. S&P 500.

2) ProShares UltraShort MSCI Europe (EPV)

As a glance at almost any morning’s financial headlines confirms, Europe has got plenty of problems. The rise of a socialist government in France; a deeply indebted United Kingdom with a collapsing currency; and almost monthly “surprises” from the likes of Cyprus always keep the market on edge.

Overall, you’d think that betting against European stock markets would be an easy way to put some extra money in your pocket.

And the easiest way to bet against Europe is through the ProShares UltraShort MSCI Europe (EPV).

This leveraged ETF seeks daily investment results that correspond to twice (200%) the inverse (opposite) of the daily performance of the MSCI Europe Index. The index is made up of common stocks of companies in 16 euro-zone markets, and includes weightings in each of the PIIGS countries of Portugal, Italy, Ireland, Greece and Spain.

But thanks to some solid performances from the likes of Ireland, euro-zone European markets have not been a total disaster.

Unlike a bet against emerging markets, this position has been close to flat this year.

This leveraged position is down 4.4% in 2013. Had you shorted its un-leveraged cousin, the Vanguard MSCI Europe ETF (VGK), you’d be essentially flat.

Bottom line? Betting against Europe as a whole is not quite as much of a no-brainer as you might think.

3) ProShares UltraShort DJ-UBS Commodity (CMD)

The surprising development in 2013 for commodities bulls was that commodities continued their recent decline, even in the midst of a reasonable global economic recovery and in the face of the much-vaunted commodity “supercycle.”

Unlike commodity bulls, I have argued the commodity super-cycle is dead. And if you look at the asset allocation strategies of the big institutional investors like the Harvard endowment, you’ll see I’m not alone. Harvard drastically cut its exposure to commodities last year in the latest version of its “policy portfolio.” And it has profited handsomely from that decision.

The best way to profit from the decline in commodities prices is through the ProShares UltraShort DJ-UBS Commodity (CMD). This ETF moves twice (200%) the inverse (opposite) of the daily performance of the U.S. dollar price of the DJ-UBS Commodity Index.

Had you invested in CMD on Jan. 1 of this year, you’d be up 8.06% — almost matching the gain of the S&P 500.

4) PowerShares DB USD Bullish Fund (UUP)

The U.S. dollar is the global currency that everyone — whether Ivy League economists, gold bugs, Europeans or Iranian dictators — loves to hate. But that’s nothing new. I remember in the mid-1980s when I tried to use U.S. dollars to pay a fine on a metro in Munich, West Germany. The conductor threw my dollars back in my face, cackling to his colleague that the U.S. dollar was worthless. (The U.S. dollar hit a record high against the West German Deutschmark a year later.)

So, those predicting the U.S. dollar’s demise have a lot of company. Yes, the explosion of government spending bodes poorly for the U.S. dollar in the long run. But as the financial meltdown of 2008 showed, when the markets get nervous, investors still rush into the U.S. dollar. Hence, the U.S. dollar is a core position in the “hedge” portfolio.

You can profit from any rebound in the U.S. dollar by buying the DB USD Index Bullish ETF (UUP), which seeks to track the price and yield performance, before fees and expenses, of the Deutsche Bank Long US Dollar Futures index.

UUP is up 3.21% thus far in 2013 — boosting the returns of foreign investors in the U.S. stock market.


So, the hedge portfolio has generated positive returns in three out four of its asset classes so far in 2013.

So what gives?

I see three possible explanations.

First, investors are irrationally exuberant toward the U.S. and Japanese stock markets; or

Second, with BRICs and commodities in the doghouse, investors feel that the U.S. and Japanese economies are the only major investment themes worth pursuing; or

Third, investors are positioning themselves in what they perceive to be the two ultimate safe-haven markets in a “risk on” world.

Whatever the answer, it’s all very strange, indeed…

To read my e-letter from last week, please click here. I also invite you to comment about my column in the space provided below.

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