Description

Main points

• Cash is more often than not a dead asset.
• Hedges are usually either an expensive drag on performance (put options) or involve blowup risk via path dependency (shorting).
• Investors wanting to de-risk or diversify risk, therefore, open themselves up to steep underperformance by hedging or by holding cash.
• An alternative is ZROZ, PIMCO’s ultra-long-term zero coupon treasury fund, which has a duration of over 26. ZROZ offers investors a sort of “cash on crack” position where they can earn a 3.7% yield today. However, if there’s a crisis and the Fed cuts rates again, investors could earn 50-60% upside. Meanwhile if rates/yields go up and stay up to the tune of 75 bps, investors face only a 18% loss, giving this bet some asymmetry.
• In plain English, we’re likely at the end of a hiking cycle, which means interest rate risk, the primary risk facing 25+ year Treasury bonds is largely behind us. Meanwhile a crisis in the form of a recession or a market correction is possible, if not probable, and in that case, the Fed will probably cut rates, and long-duration bonds with virtually no credit risk like long-term Treasuries could soar in value.
• A position in ZROZ would both preserve capital and also provide some hedging in the event of a recession/drawdown.  

Thesis

Peter Lynch famously—and correctly—said that more money has been lost anticipating corrections than has been lost in the corrections themselves. The frustrating truth of this statement is compounded by the extreme likelihood that our capital markets are still in a dangerous bubble. The Shiller P/E for the S&P 500 is at 29, one of the three most expensive points in the last 150 years.

Despite concerns about the valuation of the market as a whole, all of us are finding pockets value. The concern, however, is that if there is a massive correction in the overall market, then these pockets of value will experience massive drawdowns as well. Managing money today is essentially buying stocks you like while praying that a tide of systemic risk doesn’t suddenly carry out you to sea.

This has prompted wild desperation to find hedges. Gold, bitcoin, SPY puts—all of them trade at rich valuations. There’s a bull market in pretty much everything, even in fear. What’s amazing is that most of these things are likely just as expensive and over-priced as the things they’re supposed to be protecting us from. Meanwhile strategies like buying 30% OTM puts are deeply problematic. There are two issues with this strategy. One, only Mark Spitznagel, its most famous practitioner, and perhaps several others are successful at it. Also almost all academic or professional studies of the strategy show that it does not add value over time, the reason being that the puts are too expensive. The second problem is that in order to pay off, the strategy requires a huge vol spike like those seen in 2008 and March 2020. But this doesn’t always happen. There have been many historical downturns where the market simply grinded down lower and lower without producing the explosive vol seen in 2008 or 2020. Meanwhile the strategy requires you to lose a set percentage of your money, typically 3%, year in and year out. You’re then in the weakened position of needing a specific event—the vol spike—to make you whole.

Bottom line: options are hard.

Shorting also has its own issues, namely path dependency. I would guess that far more careers have been destroyed by shorting than have been enhanced by shorting. The issue is that most of the market’s biggest and swiftest rallies occur in bear markets. In other words, the best time to short is also the time you’re most likely to get smoked out.

In view of these shortcomings, I’m suggesting ZROZ, something that produces a far smaller hedge than puts or shorts but also involves less likelihood of incurring a catastrophic loss. ZROZ is PIMCO’s zero coupon bond fund with a duration of 26+, which I believe is the longest duration of any publicly traded ETF. At its core, ZROZ is a bet that a recession occurs and/or markets correct and the Fed once again lowers interest rates.

Several factors weigh in favor of a rate cut, and only one factor really weighs against it: obviously that’s inflation. The first factor in favor of a rate cut is the Fed’s own philosophy. They’re completely wedded to the concept of wealth effects. The more scared markets get, the more they cut and print to produce wealth effects. At the end of the day, when something goes wrong, they cut. It’s what they do.  

The second factor in favor of a rate cut is that higher rates subject the federal government to crippling interest payments. Given that the national debt has swelled to 135% of GDP and the duration of the national debt is just five years, the rise in interest rates from zero to 4.5% has increased interest payments from $352B in 2021 to $640B projected for 2023. The short duration of the debt means that these payments will continue to grow, likely hitting over $815B by 2025. For reference, that’s more than the nation’s defense budget. As a result, not just the government but all of us have a huge incentive to reduce rates from where they are today and keep rates lower for longer.

On the other side of the equation, we have inflation, the force keeping rates higher. Inflation of course is the only thing that got the Fed to raise rates in the first place. However, inflation has come down, falling to 6% this February. Shelter, which is a significant component of inflation, is lagged by about a year or so. The stalling of home prices will likely act as a counterweight against future rises in inflation over the coming 12-18 months. Also while supply constraints from Covid undoubtedly have played a role in inflation, the demand side has also likely played a role. QE, runaway government spending and deficits, the explosion in consumer credit card debt are classic inflationary forces.

Anecdotally the behavior you see on the ground today is both deeply inflationary and odd. Prices have skyrocketed, and people across the economic spectrum are eagerly paying up. The price of a four-star hotel in 2019 was typically $500-600 a night. Now good lucking finding a place for less than $800-1000. Last year, my family went to Great Wolf Lodge, which is basically Circus Circus for children. It was $850 a night. But to reiterate, prices are insane, not just for essentials but discretionary items, and people are eagerly paying them. Only the future knows how all this will play out, but a recession or a correction in the market has historically cratered people’s desire to pay 50-100% more than they used to for things they want but don’t absolutely have to have.

One other thing acts as a governor on future rate hikes: SVB. Federal regulators made the decision Sunday to protect all deposits made at SVB and Signature Bank, even those over the $250,000 insured by the FDIC. This amounts to an unlimited deposit guarantee. Further hikes raise the risk of additional bank failures and thus increase the size of the implicit guarantee that regulators have now provided. They won’t want the amounts covered by that guarantee to grow and thus have an incentive to stop raising rates in the interim to put less stress on banks.

Risk/Reward

Recall that ZROZ has a duration of 26+. 26-year US treasury zero coupon bonds reached their lowest yield in April and July 2020, bottoming at 1.3%. I think it’s possible that if a crisis occurs, the Fed would cut drastically again, and yields could fall to 1.8% or so. That would make ZROZ worth 50-60% more. So each 10% position in ZROZ would not only preserve capital, it would also hedge 5-6% of losses in the rest of the portfolio.

That’s the reward side. On the risks side, let’s say I’m wrong, and rates go up 50 bps and stay there. Let’s also say that the yield curve, which is deeply inverted, normalized a bit, and as a result, the yield on ZROZ goes from 3.7% to 4.5%. In that case, ZROZ would fall 18% in value. 55% upside to -18% downside strikes me as decent risk/reward given there’s virtually no credit risk and ZROZ is positive carry to the tune of 3.7%. By contrast, many capital assets out there carry significant credit risk and, even so, are priced for negative returns for a long, long time. 

Catalyst

Recession/correction