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The stock market is probably overvalued, as indicated in GuruFocus broad market valuations. The Total Market Index is now at 92.6% of the GDP. This ratio is the “the best single measure of where valuations stand at any given moment”, as pointed by Warren Buffett. The market is positioned for mediocre long term returns, and most likely we are borrowing returns from the future. as noted by Dr. John Hussman. the founder of Hussman Economtrics Advisors, Inc.

This is the chart for the ratio of Total Market Index over GDP, updated daily:

Coincidentally, hedge fund giant David Tepper just told New York Post that 2011 will be harder and not without risk. He continued When things go up too high, they will go down, referring to the recent market surge.

What should you do at this point?

Of course you can go all cash and wait for better opportunities. That may not be a bad decision, it is what Warren Buffett did with his personal portfolio in 2006-2007, when the market was about 20% more overvalued than it is now.

Warren Buffett was lucky that he could put his money in much higher yielding treasury bonds or CDs in 2006. Today we don’t have this luxury as every safe investment yields close to nothing. You have a much higher risk of missing potential gains in the stock market if you are out. All of us have seen many times that the market went from overvalued to extremely overvalued. It can be painful to miss all the gains.

So you want to stay in the market? Then you need to be fully aware of the risks and possible outcomes at this level of market valuation. You probably need to be defensive with your portfolio.

Hedging seems to be an interesting idea at this point.

If you hedge your stock holdings with another group of securities that move in the opposite direction of the general market, the total performance of your portfolio will be the difference in the performances of your stocks and the hedges. If you are fully hedged, ideally your performance is de-correlated from the general market. You make money as long as your long positions gain more than the hedges, no matter how the general market does.

Like John Hussman. you can hedge your long positions with the index options that move in opposite direction of the general market. In this way your performance is equal to the outperformance portion of your stocks relative to the market. You can also hedge your portfolio by shorting a group of stocks that you think that will underperform the market. This is what many hedge fund gurus do: David Einhorn of Greenlight Capital, John Griffin of Blueridge Capital etc. Your gains come from both the outperformance of your long positions relative to the market, plus the gains from the underperformance of your short positions relative to the market.

This is what David Einhorn has been doing in 2010. He wrote in his latest shareholder letter: “…we generated a satisfactory result as our longs significantly outperformed the market, our shorts modestly underperformed the market (good for us), and our macro hedges, most notably gold, generated additional profits. The result was a full year net return that approximated the S&P 500, with very low correlation to the market and much less volatility .”

Of course, there is risk.

An example here is John Hussman. Thinking the market overvalued, John Hussman keeps his portfolio fully hedged through most of 2010. His stocks underperformed the market, he lost 3.6% with this fund in 2010 while the market gained more than 15%.

It can be worse if you hedge with long-short strategy. Your long positions may underperform the market, while your short positions gained more than the market. You lose in both directions. It can be painful.

The safer ways

If you believe that over long term, undervalued stocks always outperform the market, and overvalued stocks underperform the market, you may run a long-short strategy that long undervalued stocks and short overvalued stocks.

If one runs a portfolio by being long on the undervalued stocks and being short the same amount of overvalued stocks, the performance of the portfolio will be decided by the difference in the performances of the undervalued stocks and overvalued stocks. The shorted stocks serve as the market hedge, and the portfolio will be market neutral. The performances of the general market will not affect the returns of the portfolio. If the undervalued stocks gain more than the overvalued stocks when the broad market goes up, and lose less when the broad market goes down, this portfolio should deliver relative steady gains regardless how market goes.

As we discussed before, we created model portfolios of overvalued stocks after running the model portfolios of undervalued valued stocks for two years. The portfolio of Overvalued Predictable Companies consists of the top 25 stocks that have high predictability rank, but are most overvalued as measured by their intrinsic values; the model portfolio of historical high P/S ratios consists of the 25 highly predictable companies that are sold at historical high P/S ratios. We use these two model portfolios to hedge the model portfolios of undervalued stocks and predictable companies that are traded at historical low P/S ratios. We want to observe the performance differences of the undervalued stocks and the overvalued stocks. We want to see whether we can hedge the market risk by being long with relatively undervalued stocks and short with overvalued stocks.

So far so good! As of yesterday, our undervalued predictable model portfolio underperformed by the market by 0.67% since rebalanced on Jan. 1, but the overvalued predictable companies underperformed much more, by 3.04%. Therefore a fully hedged long-short strategy gains 2.37%, almost uncorrelated with the market.

The model portfolios of historical low/high P/S companies did even better. The model portfolio of historical low P/S companies outperformed by 0.66% this year, and that of historical high P/S underperformed by 2.26%. Therefore a fully hedged P/S strategy gains 2.92%.

Time is still too short for us to conclude for the strategies. But as value investors, we do believe that over long term, stock valuations will be back to their historical means. Undervalued stocks will outperform, while overvalued stocks will underperform.

To access the model portfolios and their corresponding stock screeners and look into this hedging strategy, a premium membership is required. As always, if you are not a premium member yet, we invite you for a 7-day Free Trial of the premium membership.

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