When I started “Market Musings” at the beginning of June, one of the first pieces I wrote laid out a basic bullish case for stocks. I still believe that scenario is in place, but, for a number of reasons, another correction in the next week or so would come as no surprise. Fluctuations in the market are a fact of life for investors, but with memories of 2001 and 2008 still fresh in many people’s minds, they are still troublesome. There are countless studies that show that those who are investing for the future should not try to time these moves, but when the day comes that sees a 300+ point drop in the Dow it can be hard for investors to just sit tight. The trick is to find something that gives peace of mind without blowing up any long term strategy.
Before we get to that, let’s take a look at why I believe another one of those worrisome corrections could be just around the corner.
Downward Revisions Likely: This current earnings season has been so-so. There have been a few spectacular beats, but also many well publicized misses. Forecasts and earnings usually follow a pattern. If results are anything less than stellar, then analysts forecasts for the next quarter tend to get downgraded, enabling more beats next time around. This sometimes has the feel of a silly game, but a series of downgrades and/or downward revisions of expectations can put short term pressure on the market.
The Market Appears To Have Topped Out: For those that like to look at charts, the 3 Month representation of the S&P 500 (SPX) shown below has a worrying appearance.
It would seem that the strong upward momentum following the June drop has stalled. Should any coming rise fail to breach the 1593 level attained last week, then a temporary downward trend would be confirmed, indicating a pattern of lower highs and lower lows.
We’ve Had A Good Year: This may seem like a positive for the market, and over time I believe it will be. In the short term, however, there is always the possibility that both retail investors and fund managers will be tempted to take some money off the table to protect returns. This often happens around the end of the 3rd quarter in strong years, but if there is any sign of weakness the temptation to cash out early will be strong and add to any downward move.
You may notice that none of these are solid things grounded in fundamentals. They are all about perception. As I have said many times, however, when it comes to markets, perception is reality, at least in the short term.
It is possible that some real disaster could come about. Not necessarily a ground shifting, “black swan” type of event, more of a “black cygnet” that temporarily derails the market. Europe, China and the Middle East are all still candidates, but it is in the nature of these things that they come from somewhere unexpected. Even small things will weigh heavily on the market, as human nature leads people to pay more attention to bad news toward the end of a good year.
Any of these things could precipitate a correction and once it starts, they will all add to it. The thing is, it will most likely be just that…a correction. Given that, it doesn’t make sense to do anything drastic with your portfolio when it comes. Decades of working with both traders and investors have led me to the conclusion that the trick at times like that is to convince yourself that you have it covered. Taking some action that will benefit you on the way down will usually avoid you making bad decisions.
One such action would be to buy a leveraged Bear ETF such as the Proshares Ultra Short S&P 500 ETF (SDS) or the Direxion Small Cap Bear 3x (TZA). These are not suitable for holding for any period of time; they are more traders’ tools, but they will rise in a falling market and give the peace of mind that you need.
The other alternative for those familiar with options is to buy the VIX, a measure of options implied volatility commonly referred to as the “fear index”. The easiest way to do this is through an ETF such as the iPath S&P 500 VIX Short Term Futures ETN (VXX). Again, a word of warning. This and other similar products are, like the leveraged bear ETFs, designed for short term holding. They will lose value over time, due to contango.
Neither of these are long term, investment strategies. They are simply insurance policies for your portfolio and, as with most types of insurance, you actually hope to lose money when you buy them. For this reason, you should not attempt to hedge the value of your entire portfolio with them. If, like me, however, you believe that a correction is coming, then a small investment in either one may be a good idea. If the correction doesn’t come, sell your position for a small loss and be thankful. The purpose here is to have something going up in a falling market. The feeling that you are doing something about it will stop you making any more drastic moves and be of benefit in the long run.