The Texas Hedge
Should we really be doubling down on equities?
As we approach the end of the year, there’s no doubt that US equities have enjoyed an exceptional 2024. Yet we’re in a situation whereby equities have continued to rise in recent months despite inflation (actual and expected) ticking higher.
Some say that makes sense, as they argue that stocks can be used as an inflation hedge. On that premise, there’s the argument for doubling down on equity exposure if an investor feels inflation will move higher in 2025. This can be dubbed as a ‘Texas Hedge’, which is an expression used to reflect increasing risk on a position rather than reducing it.
However, we find this view flawed at best and feel that investors are confusing short-term correlation with causation. Below, we outline why equities (in general) next year might struggle to provide an inflation hedge, where some pockets of opportunity might be found and some trade ideas for how to actually protect against higher price levels.
The Texas Hedge
The story goes that a Chicago floor runner asked a trader if he was sure his order of buying futures contracts was correct, as the trader was already long the market via purchasing call options. The supposed response that came back was along the lines of ‘I’m from Texas! We don’t hedge when we’re right, we double down!’
Whether this is a mere fable or not, the term is used more broadly to play on the stereotype of Texans as bold, risk-taking individuals.
Why Some See Stocks as a Hedge
Before outlining why we disagree, let’s briefly run through why some have a high conviction on using equities to protect against inflation.
Equities are a ‘real’ asset
Granted, a stock certificate isn’t a real asset in the true definition of the term. But you get what we mean here. In theory, the value of a stock should rise in line with inflation because the company itself is benefiting from inflation via higher revenue.
Companies can often pass higher input costs (e.g., labour, materials) onto customers through price increases. This further allows their revenues and earnings to grow in line with or even exceed inflation.
Stocks represent ownership in businesses that often hold tangible assets (we think of real estate, factories, commodities, etc), which tend to appreciate in value during inflationary periods.
Recency bias
As the name suggests, this is a cognitive bias that causes individuals to give disproportionate weight to recent events and information when making decisions or evaluations. This bias occurs because people naturally focus on what is fresh in their memory, often at the expense of a more balanced or historical perspective.
When we look at the performance of the S&P 500 (shown below in green) versus CPI inflation over the past few years, it’s easy to claim that stocks acted as an inflation hedge:
The index barely stopped for breath during Q1 2021 when inflation started to materially spike. Even though equity gains were capped during much of 2022, there wasn’t a material inverse correlation.
Dividend yield
Finally, some flag up the income generated from dividend shares and use the dividend yield as an easy barometer with which to evaluate and beat inflation.
For example, below are the top 10 highest-yielding stocks within the FTSE 250 index at the moment, with yields all in excess of 9%:
The argument made is that these assets can translate to making an investor a real yield (i.e. nominal dividend yield - inflation), even during periods of high inflation.