When you have been around investments and economics as long as
I have, you hear certain phrases over and over again. These are a
common few:
* Don't put all your eggs in one basket.
* You can't fight the Fed.
* A rising tide lifts all boats.
Most of these sayings have some merit. One that I've heard on
several occasions that tends to worry me is, "it's different this
time." I've heard it often enough and been around this industry
long enough that I actually used that phrase as an article title
ahead of the recession in 2007 and 2008.
This time I'm not talking about an inverted yield curve, but
rather two sentiment indicators reaching bullish extremes. The
Investors Intelligence Report (II) measures bullish and bearish
percentages among investment publishers. When the bullish
percentage has reached a level three times higher than the
bearish percentage, corrections have occurred.
The other indicator is the CBOE Volatility Index (VIX), which
recently breached the 16 level. The VIX is often referred to as
the fear gauge of the market. When the VIX is high, fear is high.
When the VIX is low, fear is low. As a contrarian, when fear is
low, I get worried. Over the last five years, when the VIX has
breached the 16 level, it has been a warning sign.
Take a look at the chart below. It shows the months when the II
and the VIX breached their warning levels and how the S&P
reacted in the ensuing months.
What this chart suggests to me is that we are playing with fire
in the market right now. Sure there have been a few times when
the market moved higher for a short period following these
signals, but the moves higher were short lived and they were not
big moves. It seems there is more risk than reward right now. I'm
not suggesting that we are in for another bear market like
2007-2009, but rather a correction. I foresee two or three months
of selling that causes the indexes to dip approximately 10%-15%.
The overbought/oversold indicators on the monthly charts are the
highest they have been since 2007 as well, and a pullback would
go a long way toward getting the indexes out of overbought
territory.
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Now, I'm not suggesting that you rush out and sell all of your
stock holdings, nor am I suggesting that you load up on nothing
but puts at this point in time. It would be prudent to take some
gains off the table on any long positions you may have. It's also
not a bad idea to add some insurance in the way of puts on the
main exchange-traded funds (
ETF
) like the
S&P 500 SPDR (
SPY
)
. This would allow you to hang on to your stock holdings but have
a hedge against a decline. Just like insurance on our car, we
hate paying the premiums, but we sure are glad we have it when we
need it.
If you're not a fan of options, but would like to add some
protection against a possible correction, you could add an
inverse ETF to your portfolio. If your portfolio is made up of
mostly blue chip stocks, an inverse ETF on the S&P 500 would
be your best protection:
*
ProShares UltraShort S&P 500 Fund (
SDS
)
--This is a leveraged ETF that goes up 2% when the S&P
declines 1%.
*
ProShares Short S&P 500 (
SH
)
--This is a regular inverse ETF that is designed to go up 1% when
the S&P declines 1%.
If your portfolio has a lot of tech stocks in it, you might want
to consider an ETF that is based on the movements of the QQQ.
*
ProShares UltraShort QQQ (
QID
)
--A leveraged inverse ETF designed to increase by 2% for every 1%
decline in the Nasdaq 100 Trust (QQQ).
*
ProShares Short QQQ (PSQ)
--This is a regular inverse ETF that is designed to go up 1% when
the QQQ declines 1%.
There are inverse ETFs for individual sectors and many other
indexes. You will want to pick one that gives you the best
protection based on the holdings in your portfolio. Again, I'm
not saying that another bear market is on the horizon, but a
correction looks like a very high probability scenario.
It could end up being different this time, but history suggests
otherwise and taking out a little insurance to protect your
assets isn't a bad idea.
Sincerely,
Rick Pendergraft
For Cabot Wealth Advisory
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