There were two changes to my portfolio this month. Out went Local Shopping REIT. This is a perfectly good retail property outfit. However, I can't see much positive happening either on the high street or within the wider real-estate investment trust (Reit) sector for quite some time - plus, at current price levels most Reits aren't priced at bargain levels. Crucially I’m freeing up cash wherever I can so I can buy good quality shares at cheap prices later in the year.
In comes a chunky investment in a slightly mysterious-sounding exchange traded fund (ETF). It's called the Source Nomura Voltage Mid-Term ETF (ticker: VOLT). This is essentially a form of hedging for the equity part of my portfolio.
This ETF invests in a series of rolling monthly volatility futures contracts. This essentially boils down to buying options contracts on the price of a volatility index for between one and 12 months (although probably at the lower end of the range). What I'm basically buying into is a three- to four-month bet that the markets are about to get much more volatile as macroeconomic worries come to the fore.
If one looks at current volatility levels measured by indices such as the VIX (and VFSTE here in the UK) you'll see that daily price changes are very low and markets seem calm. But we all know this is ridiculous and that any number of issues could unsettle the markets very quickly and cause prices to shoot down sharply.
The VOLT tracker is a way of playing this potential trend without being eaten alive by the costs of constantly rolling forward futures contracts - this 'carry cost' as it's called in the trade can potentially destroy any returns from a hedging strategy even if you've correctly guessed the direction of a major market trend. I think the 'bump' or even 'bumps' will happen before the end of January 2013 and this is a way of playing that potential scenario. The key, though, is that it isn't a long-term buy-and-hold idea. If markets stay calm, and volatility doesn't budge, I'd cut my losses within a few months and sell.
The big question in this context is what might unsettle the markets? The obvious wild card is Europe. The recent European Central Bank (ECB) board meeting and the subsequent comments by Mr Draghi underline two issues for me at the portfolio level. The first is that the euro won't fall apart and thus the world as we know it won't end in the next few weeks or months, although I'd put the odds on Spain seeking a bailout at 70 per cent. This view underlines my very positive view for equities over a 12-month to five-year timeframe - which is why I'm trying to free up cash to buy equities later in 2013.
Unfortunately the news that the ECB will start buying shorter-duration bonds is far from the end of the story, as there continues to be a huge amount of uncertainty about what this support actually means. My hunch is that the markets will carry on testing the resolve of the ECB until they have something else to worry about.
That 'something else' might be about to emerge from the US - where continued political deadlock is a real possibility after an Obama re-election - or from China (where the economy is slowing much faster than we all thought) or even Israel and the Middle East.
I think that that 'something else' is much more likely to be innocuous and absolutely won't sound like the end of the world as we know it. It's called the profits cycle and it reminds us that the stock market moves along with its own peculiar motions, with profits anticipating changes in the wider business cycle, and the markets anticipating both the profits and business cycle.
A recent note from uber-bear Albert Edwards from French bank SocGen in London, reminds us of these hard facts. Mr Edwards and his colleague Andrew Lapthorne have been charting the relentless decline in earnings growth in the core US market as well as analysts' estimates of this change for months now. His latest paper simply warns us that even the US is now beginning to enter recession. Profit margins have been way too high for too long - which partly explains why consumers still feel so impoverished - and the inevitable wave of earnings disappointments will now sweep the all-important US markets. For Mr Edwards this means that the final wave of his "global ice age for stocks" is about to strike fear and terror into the market, with sharp falls as equity investors capitulate. I can't say I'm remotely that bearish but it does seem obvious to me that equity investors should be much, much more worried about profits growth and industrial output than what might happen next at the ECB.
