Safe Minus Risky: Do Investors Pay a Premium for Stocks that Hedge Stock Market Downturns?

Abstract

Stocks that hedge against sustained market downturns — periods from peak to trough in S&P500 levels at the business cycle frequency — should have low expected returns, but they do not. We use ex-ante firm characteristics and covariances to construct a tradeable Safe Minus Risky (SMR) portfolio that hedges market downturns out-of-sample. Although downturns correspond to significant declines in GDP growth, SMR has significant positive average returns and four factor alphas (both about 0.75% per month). Risk-based models do not explain SMR’s returns, but mispricing does. Risky stocks are overpriced when sentiment is high, resulting in subsequent returns of -1% per month.

Keywords: Bear Markets, Expected Returns, Risk Factors