Doug Casey’s Crash-Proof Portfolio: How to Make Money When Stock Markets Crash

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by Doug Casey, International Man:

It’s impossible to be sure, at any given moment, whether any market is going up or down. No matter how overpriced a market may be, there are always bulls with good-sounding arguments about why it could go twice as high. No matter how “cheap” a market may be, there are always convincing bearish arguments for it to go lower.

After all, for every buyer, there’s a seller (and vice versa). The same is true for the economy, where a case can be made for both good times and bad times at almost any juncture.

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How can you hedge yourself against being on the wrong side of the market? By using “hedge” strategies which are surprisingly little-known, though they’re almost always lower-risk and have higher potential than pure long or short positions.

A “hedge” is a position where you buy X dollars’ worth of one stock or commodity and simultaneously short sell an equal dollar amount of a different stock or commodity. Since you’re both “long” and “short” the market, you don’t really care which way it goes. By choosing your positions intelligently, you can be right on both sides of your trade, regardless of overall market conditions.

As fashions change, the first tend to become last and the last become first. This was recognized in biblical times, and it’s equally certain in the investment markets. Regardless of the overall direction of the market, relatively overpriced stocks tend to decline and underpriced securities tend to rise. Indeed, both movements often happen at once.

By being both long one investment and simultaneously short another, you can escape the need to second-guess the direction of the overall market and still profit in either a bull or bear market. The keys to profitable hedging are patience and consistency: patience because it doesn’t make sense to be in any market all the time; consistency because your plan won’t work if you don’t follow it.

Most of the time, it’s a 50/50 bet whether something is going up or down, and you need better than 50/50 odds to make money. The idea is to be in a given investment only when the odds of it going up appear to be 90% or better and to be short when the odds of it going down are equally strong. It is fortunate that odds that strong usually identify investments that are getting ready to move 10 for one or more as well.

Suppose, for instance, you like the prospects of Stock X. You’re sure the underlying company will do well. But you’re afraid of the market as a whole, which could take Stock X down despite the company prospering. How do you solve the dilemma of whether to buy or to wait?

A hedge might be the answer. Find another company in the same industry, Stock Z, which you feel has terrible prospects and perhaps will lose business because of Company X’s success and whose stock looks to be overpriced. Then, buy Stock X and short an equal dollar amount of Stock Z.

If your assessment is correct, it will not make any difference how the market in general, or the industry in particular, does. You’ll make money as long as X does better than Z—whether they both go up or they both go down. And, if their prices move in opposite directions, you can make money on both and double your profits, even while you’ve reduced your risk.

Value is relative, not absolute. In other words, you want a position not only because of what it is, but because of what price it is.

It’s never a question of how many dollars you can get for something you want to sell. The real question is how many shares, or contracts, or acres, you can exchange it for. It might, for instance, be hard to say whether corn is cheap or dear at, say, $4 a bushel unless you know what to compare it with. But we know that wheat usually sells for about twice the price of corn and soybeans for about triple—because of factors like production costs and protein content. If soybeans sell for $6 while corn is at $4, you can be pretty sure corn is dear, at least relative to beans. By selling corn and buying beans, you’re likely to make money.

The idea is to pick out very cheap stocks or commodities to buy, and very dear ones to sell simultaneously, with the intention of protecting yourself from general market moves. Buy and sell respectively equal dollar amounts of each and wait for the inevitable without caring whether the market in general booms or busts.

An Example

In 1991, I recommended such a hedge in the thrift industry. It provides an ideal illustration of the principle.

Continental Federal, a savings and loan bank based close to Washington, D.C., was selling for $5—less than a fourth of its $22 book value, and about a fifth of its previous high of $27. An analysis of its balance sheet showed it could even then have been liquidated for $15. It exceeded all regulatory capital requirements by at least two to one. All but a few of its loans were in the relatively low-risk residential market, and it had already charged off most of its bad loans.

Although management had been competent in making good loans, their overhead expenses were very high at 320 basis points of their $1.1 billion of assets (i.e., about $35 million or 3.2% of assets).

Typically, for a public company, management was treating themselves quite well at shareholders’ expense. Why? They owned only 100,000 of the 2.9 million shares outstanding. Overhead should be no more than 250 basis points (2.5% of assets), and a difference of 70 points on $1.1 billion is about $8 million per year. If management were forced to tighten their belts by only that much, the stock could easily sell for at least $12 per share.

A group of shareholders, including myself, joined together to make it happen. Still, because of my misgivings about the economy at large, I did not want to be long Continental Federal without being short an equal dollar amount of something likely to join the choir invisible. GlenFed, the third-largest thrift in the United States, with most of its assets in California, seemed like a good choice in that category.

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