Goldman Sachs: The Time To Hedge Your Investments Is Now

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Goldman Sachs is one of the largest and most respected investment banks in the world. When the firm issues an opinion on the overall market, it’s usually a good idea to take note. In early July, Goldman Sachs said that now is the time to hedge your portfolio and protect yourself from downside risk.

Beyond the market’s sharp 25%-plus gain since its lows in October 2022, Goldman Sachs cites specific market characteristics that are sounding the alarm. Here are the factors that Goldman Sachs considers worrisome, along with some suggestions as to how to shield your portfolio from potential losses.

Narrow Market Breadth

While the size of the market gain over the past nine months or so isn’t necessarily troublesome, the way the market got there is, in the opinion of Goldman Sachs. Market breadth measures the number of stocks that are moving up vs. those that are moving down. Generally, it’s used to determine how many stocks are responsible for the move of a stock index upwards.

When market breadth is wide, it means many stocks are participating in market gains. The opposite is true when market breadth is narrow.

According to the investment bank, market breadth is the narrowest it has been since the Tech Bubble, which ended in a vicious selloff. Specifically, Goldman Sachs’ David Kostin wrote that “Historically, sharp declines in market breadth have typically been associated with large drawdowns in subsequent months.”

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High Valuations — ‘Priced for Perfection’

Market breadth in and of itself may not be enough to drag down the market, but when coupled with high valuations — and overly optimistic investors — Goldman Sachs views it as the perfect cocktail for market losses. 

On the valuation front, Goldman Sachs says the market is priced at 19x forward earnings, which is historically quite high. In fact, according to Kostin, “…when the index has traded at this level or above, the S&P 500 has experienced a median drawdown of 14% over the next 12 months as compared with a 5% drawdown over a typical 12-month period.”

According to the investment bank, the market is also too optimistic about the future performance of the U.S. economy, which helps prop up stock prices. While Goldman Sachs sees U.S. GDP growth of just 1% in the second half of 2023, the market is pricing in growth closer to 2%.

Bullish Sentiment

A widely used indicator to gauge future stock market performance is the bull/bear ratio. When too many investors are bullish — optimistic on the market — it’s often a cautionary sign.

When everyone thinks the market is going to go up, there’s no one left to switch from being negative to being positive. And it is this transition that draws money into the market, pushing prices higher. In other words, when everyone’s already in, there’s no one left to buy.

To a large degree, all of the money that was on the sidelines in October 2022 has already been invested.

“As 2023 has progressed,” Kostin wrote, “investors have increased their equity exposure. Hedge funds increased net leverage, mutual funds cut cash balances and foreign investors have been net buyers of equities… There are many reasonable alternatives to equities today, indicating that the flow of funds is unlikely to be a tailwind for stocks this year… With investors already bullishly positioned, it may be harder for the market to rally further from here.”

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Cheap Hedging Strategies

Goldman Sachs hasn’t come out and said that investors should sell all of their equities. Rather, it suggests that hedging is a more appropriate option, in large part due to the affordability of various hedging strategies at the current time.

One of the most common hedging strategies is to buy put options on market indices or individual stocks. A put option goes up in value when its underlying security goes down, making it a perfect hedge. If you wager wrong and the market — or a stock — goes up instead of down, all you can lose is the premium you pay for the option, while you still enjoy the gains of the underlying security.

Currently, according to Goldman Sachs, the premiums for put options are relatively cheap vs. those of call options, which move in the same direction as their underlying securities — i.e., they go up in price when a stock or index goes up in price. This makes buying this type of “insurance” a relatively affordable way to hedge your positions.

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