How To Protect A Portfolio In Consumer Discretionary

Sectors are some of the factors that may influence the choice of going to cash, hedging, or doing nothing when entering a bear market. My previous articles of this series gave examples for consumer staples, industrials, healthcare, energy and materials (last episode here). This one will focus on the S&P 500 Consumer Discretionary sector.

For each sector in the S&P 500 universe, I defined a fundamental ranking process. My Consumer Discretionary Ranking uses three fundamental factors. One of them is the total debt to equity ratio. For the next part, I will use a strategy consisting of a 4-week rotation of the ten stocks of highest rank. It represents about 12% of the reference set: there are currently 83 consumer discretionary companies in the S&P 500 index. This is not one of my investing strategies, but a model of portfolio in materials using common sense and simple fundamental factors. I find it more relevant than using a market cap-based ETF like XLY.

I have performed three 15-year simulations (1/1/1999-12/20/2013): without protection ("NP"), with market timing ("MT") and timed hedged ("TH"). The portfolio is rebalanced every four weeks. The timing indicator is the same for market timing and timed hedging. It is defined by a bearish signal when the S&P 500 current year EPS estimate falls below its own value three months ago, and a bullish signal when it rises above this value. The hedge is an S&P 500 short position in a 1:1 ratio with the portfolio value.

The next table shows simulation results. Dividends are included, transaction costs are 0.1%. A 2% annualized carry cost is applied for temporary hedging positions.

S&P500 Strategies	Tot.Return	Ann.Ret.	Drawdown	Volatility	Sortino	Correl./SPY
Discretionary-10best-NP	1142%	18.3%	-62.5%	33.4%	0.6	0.79
Discretionary-10best-MT	728%	15.2%	-31.2%	20.9%	0.62	0.49
Discretionary-10best-TH	2461%	24.2%	-36.6%	26.4%	1.15	0.46

The unprotected portfolio gives an unacceptable drawdown and volatility. Timed hedging is the best solution to maximize the total return and risk-adjusted performance (Sortino ratio) with a limited drawdown. Here is the equity curve of the time-hedged strategy (in red) compared with SPY (in blue):

(Click to enlarge)

This is a dynamic portfolio. On average, 0.6 stock changes every four weeks. Here are the four highest market capitalizations of the current portfolio:

Ticker	Company	Capital (M$)	Industry	PE*	Div. Yield
DISCA	Discovery Communications	31,019.63	Media	31.68	0
DG	Dollar General Corp	19,240.38	Multiline Retail	19.19	0
BBBY	Bed Bath & Beyond Inc.	16,623.41	Specialty Retail	16.13	0
TRIP	TripAdvisor Inc	11,811.86	Internet & Catalog Retail	55.42	0

*Trailing 12 months, extraordinary items included.

Timed hedging is modeled here in a margin account, and margin costs are included. However, it can be executed without a margin account, by selling 25% of the portfolio and buying a 3x inverse S&P 500 ETF. It gives the same protection as shorting SPY in a 1:1 ratio.

Conclusion:

Unlike a defensive sector like consumer staples, it is necessary to time or hedge a portfolio in consumer discretionary to avoid heavy losses in market downturns. Timed hedging may be a better solution than going to cash to maximize the return and limit the drawdown. If you don't want to miss my next article about another sector, click on "Follow". Additional sources of information are available in my profile.

Source: How To Protect A Portfolio In Consumer Discretionary

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Past Performance is not a guarantee for the future. (More...)

This entry passed through the Full-Text RSS service — if this is your content and you're reading it on someone else's site, please read the FAQ at fivefilters.org/content-only/faq.php#publishers.