Long/Short Investment Strategy

Long/Short strategy is used by hedge funds to moderate performance. The long short strategy would reduce your upside in a rising market , but also reduce your downside if the market is performing poorly. I mean this relative to being long only.

I know that with this strategy some hedge funds will go beyond 100% with their long positions, or have very heavy short positions, so performance relative to the market can vary depending on how the fund is setup.

Though this strategy is used mostly by hedge funds this is something that can just as easily be utilized by the average investor to reduce portfolio volatility.

The definition of long/short strategy according to Investopedia is as follows:

"Long/short equity is an investing strategy that takes long positions in stocks that are expected to appreciate and short positions in stocks that are expected to decline. A long/short equity strategy seeks to minimize market exposure while profiting from stock gains in the long positions, along with price declines in the short positions. Although this may not always be the case, the strategy should be profitable on a net basis."

So why is this long/short relevant right now you might be asking? I believe it is relevant due to the detachment from fundamentals within certain areas of the market right now. Just take a look at this analysis from Yardeni Research published on July 16th of forward 12 month price earnings ratios. They are over 20 where it has historically been anywhere from the low to high teens maximum.

That said p/e ratios are much more elevated in certain areas like consumer discretionary at approximately 35.0. The decrease in forward earnings estimates makes sense, because if we are in a recessionary environment discretionary expenditures are the type of expenses that people will cut back on the most.

Meanwhile for consumer staples those ratios are still within the range of where we've been over the past few years in the high teens. These ratios are saying in a large way that the stock market is valuing in an economic recovery in a big way. A v-shaped recovery, and if we continue to run into hurdles which we're starting to see with the slowing down the rate of the re-openings in some states this could be a significant risk factor.

So from our perspective we have opened up a short position representing approximately 10% of our portfolio using the SPY when the s&p 500 was between the 3100-3200 levels, and we plan to slowly increase the sizing of this position if the market starts approaching higher levels such as 3400 to 3600, 3700 to 3900, and 4000 to 4200, and so on and so forth. These numbers on the s&p might sound crazy but the federal reserve has just pumped trillions of dollars into the market, and there is an abundance of liquidity and cash sitting on the side line.

Then if we have a significant correction again like we did in March we would begin to slowly unwind short position as things get below our average cost on the short position, and begin to peck away on the companies that we wanted to buy and the target prices we have set. It's really hard to get market timing perfect that's why we take this sort of measured approach.

Additionally, we've also shorted some individual companies. Companies that have got really ahead of their skies as part of the stay at home trade.

If you guy have some thoughts on strategies on how you hedge your portfolio feel free to comment below I'd love to hear about it. Do you put shorts on the market or individual stock, or even sector etfs? Do you have a ratio you use like 130% long and 30% short for example? Let me know in the comments below.

LINKS:

https://www.investopedia.com/terms/l/long-shortequity.asp

https://www.yardeni.com/pub/mktbriefsppesecind.pdf