Why invest in an underperforming index fund?

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Michael Fowlkes 12/09/2013

2013 is winding to a close, and the vast majority of investors can look back fondly on the past year. By all accounts, it's been a great year on Wall Street.

Since the start of the year, all of the major indexes have traded higher, with the NASDAQ posting an impressive 34.7% increase year to date. The other indexes have also been strong, but the Dow Jones and the S&P 500 have only notched gains of up 22.9% and 26.5% respectively.

With the NASDAQ tech-focused, it is easy to understand why it has outpaced the other main indexes during this current bull run. Tech stocks tend to be more volatile, and will often rise in value faster than other sectors, but fall quicker in bear markets.

The current economic recovery has been steady, but has not been accelerating the way some traders would like. As a result, traders are turning to the NASDAQ. Due to the nature of the industry, technology companies tend to grow faster, which is what has attracted investors this year.

The real question is what can we expect moving forward. With the NASDAQ hitting the 4,000 level for the first time since the dot-com boom of the early 2000's, there is already a lot of chatter regarding a possible tech bubble. It is easy to understand these fears, but most analysts agree there are big differences between then and now, and that we are not in that great of a danger of seeing a major sell off any time soon.

The Dow Jones and the S&P 500 have hit record territory this year, while the NASDAQ remains well below its record high of 5,048 set back in March 2000. The level of euphoria that surrounded technology back in 2,000 is simply not present in today's market.

The market does appear to be much more cautious now that it was back in 2000. At that time, expectations were so high that technology companies could accomplish anything that investors were willing to buy stocks at huge multiples to forward earnings. That is not the case anymore.

While there are some companies that are currently trading at enormous P/E ratios, like Netflix ( NFLX ) and its P/E of 298, they are more of the exception than the rule.

One of the biggest tech leaders is Apple ( AAPL ), which is trading with a P/E of 14. Google ( GOOG ) and Microsoft ( MSFT ) have P/E ratios of 29 and 14 respectively. These are not huge numbers by any account, so even if weakness does hit the broader market, we are not going to witness the same type of selloff that we saw back in 2000. Stocks simply do not have that far to fall.

There have been some wild forecasts for where the broad market is headed in 2014. Some analysts have forecast a crash, while others have forecast another year with 20% gains. I am optimistic that the market will move higher, but am more conservative in my view. I think we will see the market gain around 10% next year.

The biggest restraint to seeing another huge year is the possibility of the Federal Reserve tapering policy. The day will come when tapering takes place, and while that date remains a mystery I firmly believe it will occur during 2014.

I believe the Federal Reserve will taper slow enough as to not derail the economy or slow down the stock market too much, but I think it will prevent 20% gains for the broader market. And there is also the risk that the market will overreact and a big selloff could happen when tapering begins.

With a bullish outlook on the markets, but also seeing potential pitfalls, I would suggest taking a hedged approach to trading the market in 2014.

I would consider a hedged trade on PowerShares QQQ ( QQQ ). QQQ is an ETF that holds the top 100 stocks in the NASDAQ, so it trades in a close pattern to the overall NASDAQ.


Chart courtesy of stockcharts.com

A nice hedged trade on QQQ would be the March 74/77 bull put credit spread. In this trade you would sell the March 77 put while buying the same number of March 74 puts for a credit of 22 cents. This trade has a target return of 7.9%, which is 67.2% on an annualized basis (for comparison purposes only). QQQ is currently trading at $86.01, so the trade has 10.2% downside protection.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

Originally published on InvestorsObserver.com


This article appears in: Investing , Options

Referenced Stocks: AAPL , GOOG , MSFT , NFLX , QQQ

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