My overall market view has changed, or at least moderated, over the last week. Two weeks ago I believed any correction to US equity markets would be small and short-lived. I have said before that twenty years in the Foreign Exchange market teaches one to have a healthy respect for a determined Central Bank. Taking on the Fed is generally bad for your wealth. There were other reasons for an overall bullish tone to my musings as well. Corporate profits remained high, the economy is recovering slowly and, if history is a guide, the posturing over sequestration will lead to some kind of workable, if temporary , agreement.
As I said, that was two weeks ago, a long time in punditry and an eternity for a trader. Since then there have been signs that the housing recovery is not as robust as we thought, that Europe is still in trouble, and that consumer confidence and spending are beginning to plateau. While a budget deal to avert sequestration is possible, a period of stupid, worrying statements from our beloved representatives is a certainty. These are all worries, but they are old worries. What changed last week is that the word “determined” can no longer be reliably applied to the Fed.
Actually, the minutes released last week weren’t that much different from before. It was just that there was mention that some Board members were worried about the inflationary effect of current policy. This has been the case for a while, so what has changed? What is different is the perception of the market. The Fed is no longer seen as invincible; there are chinks in their armor.
I have seen this first hand. I was on a Sterling/Mark desk when the Old Lady (The Bank of England) was forced to pull out from supporting Sterling on September 16th 1992, leading to a withdrawal from the European Monetary System. Weakness had been sensed during that day and seemingly everybody and their dog were short and getting shorter. The BOE was the only buyer. An entire market hunting as a pack with the smell of blood in its nostrils is a frightening thing.
Of course, the Fed has been buying Treasuries, not supporting the stock market directly. The effect though is the same. As bond yields have been driven lower, so money chasing a return has been forced into the stock market. There is plenty of money chasing a return too, with the Fed adding $85 Billion dollars per month of liquidity. Any hint that this could come to an end is likely to cause sustained selling in both bonds and stocks.
Friday was pretty ugly, so a bounce back early this week is to be expected. In the long-term, I believe that the recovery will continue, and the market will reflect that. My concern is that before long, we could see a sustained move down, a mini-crash even. I am not a doom merchant, nor am I going to scream that a collapse is coming immediately; I just believe it is now possible over the coming weeks.
Given this possibility, what should you do? The short answer is “something”. I know from my own experience, and especially from my time as an advisor, that stopping yourself from making mistakes is one of the most important things you can do. Many advisors will tell you to do nothing, to ride out any storm. The issue for most people is that they do this for a while, and then start dumping stock when the pain gets too great. The classic buy high, sell low behavior. Taking a small position now in something that will benefit from a lower market is a smart move. If a drastic move down comes you will feel that you have done something and be less inclined to sell out near the bottom.
Generally I am not a fan of leveraged bear ETFs. They are traders’ instruments best used for intraday hedging. Daily re-sets and a high fee structure make them completely unsuitable for long term holding. In this situation, however, where you have concerns over the next few weeks, a small position in something like the Direxion Small Cap 3X Bear ETF (TZA) would be a good idea.
If the sequestration issue is sorted, the Fed stands firm and the recovery picks up pace, you won’t do too much damage in a couple of weeks. If my fears are confirmed, however, having something in your portfolio that is making money can stop you from making rash, emotional decisions. As always, hope for the best, but prepare for the worst.