An Election-Proof Strategy

 | Nov 05, 2012 | 2:30 PM EST
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Today everyone will be talking about the fast-approaching U.S. presidential election, and which sectors will do well under the various potential scenarios. As natural contrarian, I have no intention of doing that, as I believe it is a futile exercise. Under any scenario we'll have a government with sharp divides along party lines, and nothing much stands to actually be accomplished. Making bets on the unknowable is not my style, so I will try to focus on things that might make us some money regardless of occurs in Washington over the next few months.

I want to start the week by evaluating my hedged model portfolios. I started out this spring looking at different ways to hedge a portfolio of stocks using the S&P 500 Index and its components. Since then, two strategies have thus far proven to be winners. A few others have made into the round file as being totally ridiculous assumptions with seemingly no merit or potential. So far we only have about a half a year's observation, so this needs more testing and observation -- and the market has generally been rising, as well, so we don't know how well the hedge will work in a price collapse. Still, the results so far have been interesting.

 One of the two successful model portfolios has involved buying equal amounts of S&P 500 stocks that are trading below book value -- and, as a hedge, selling an equal amount of an S&P 500 ETF. In our first observation period, this portfolio would have gained 4.52%, fully hedged. This time around, over the past two and a half months, the fully hedged portfolio would have risen 4.57%. For the entire period, the portfolio would have returned 9.39% fully hedged. The hedge itself lost about 40 basis points since mid-August. Over five months, the portfolio is doing better than the overall market, and with less volatility.

The real winner, once again, has been going long equal dollar amounts of the  index  that have lost more than 50% over the past year, and shorting an index ETF in an a value equal to the aggregate value of the longs. In our first observation, the model portfolio gained 6.28% fully hedged. This time, the fully hedged portfolio would have gained 12.61%. This hedged approach is beating the market by a wide margin so far, with a total return of 13.68%.

Where all this gets really interesting is when you look at the unhedged long components of the portfolios. The book-value model portfolio saw 75% of the portfolio stocks rise, for a total gain of more than 9% in just 10 weeks. That follows a 19% gain in the first test periods. The largest gain was in GameStop (GME), with a 42% rise, while Cliffs Natural Resources (CLF) was the biggest loser with a 13% drop. Buying S&P 500 stocks trading below book value is an approach I have used and tested extensively, and it continues to work.

Buying the 52-week losers in the index has delivered spectacular returns. In the first test period, the unhedged model portfolio gained 22.67%, followed up with a gain 25.73%. That's a six-month climb of 54.23%. This time around, all of the stocks in the portfolio went higher, led by coal stocks such as Alpha Natural (ANR) and Peabody (BTU).

Given the performance of these stocks, if I were a trader I would eschew the darlings or market leaders and start looking to the losers and unloved stocks in the index. They seem to offer greater trading opportunities and the potential for strong gains. I have long thought that even traders would do better by doing what no one else is doing -- by looking at stocks other traders and momentum types avoid.

I will reset these portfolios Monday, and on Tuesday we will look at their composition.

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