Most investors will have been encouraged by seeing when they woke up this morning that stock market futures are significantly higher. As I write, those futures are indicating the Dow will be up a couple of hundred points at the open, with the Nasdaq recovering enough ground to pull it out of the official correction territory that it hit yesterday.
Dig a little deeper into the reasons for the bounce, however, and those who understand volatility in markets will be looking at this as an opportunity to essentially buy some cheap insurance.
To do so, you don’t necessarily have to believe that the sky is falling. You can believe, as I do, that the underlying, fundamental conditions for U.S. stocks are good, and that while interest rates stay low, they are by far the most attractive investment available.
Prices are being hurt by policy decisions, but those are reversible and the closer we get to an election year, the more likely it is they will be reversed. There is, however, many a slip twixt cup and lip.
When that reversal comes, it may already be too late to avoid substantial damage. In fact, one could make a case, based on the Manufacturing PMI data released yesterday, that it already is.
The numbers showed the first contraction in orders since 2009, with the index hitting its lowest level since then too. That is concerning, but it should be borne in mind that manufacturing has been on a tear for a couple of years, so some slowdown is understandable. If we were to continue down from here to pre-recession levels, then it would potentially be a sign of impending doom, but as it is, PMI is at a level that when last hit, was followed by a sustained expansion.
What yesterday’s data does though, is highlight the argument for insuring your portfolio is some way, and this morning’s bounce shouldn’t put you off that idea. Remember, volatility is rapid, unpredictable movement in both directions, not just downward.
It is often followed by a serious drop, which is why it is so worrying, but big moves up are as common as down in the initial bout of volatility. It makes sense to use those moves up to protect your investments.
Once again, what I am talking about here is insurance. On balance, the interest rate situation, a healthy jobs market, steady, if not spectacular, growth and low inflation all point to long-term gains in stocks. In the short to medium term, however, a sharp drop on trade worries and weaker data looks on the cards.
Not overreacting to that as it unfolds is far easier when you have acknowledged the possibility in advance, and especially when you have purchased something that makes money on the way down.
My choice, as it usually is in these situations, would be a leveraged, inverse S&P 500 Index ETF, such as SDS. This fund is designed to offer double the returns of the S&P, but inverted: When the index goes down, this ETF goes up twice as much in percentage terms and vice versa.
You will find many warnings about this kind of thing out there, with lots of articles about how they are unsuitable for most investors. Ironically, the “problem” highlighted in those is exactly what makes it a good vehicle for short-term portfolio insurance: They are designed for short-term use.
They are reset daily and achieve leverage using futures. Those two things increase costs and expenses, so that actual returns on the upside (when the index falls) usually fall short of the target, while losses can be somewhat exaggerated. The longer you hold them, the more pronounced that effect, but knowing that ensures that you won’t just hold on to SDS, you will cut it before too long, whether for a profit or a loss.
There are other, more complex ways of achieving a similar thing such as writing covered call options, or being active yourself in the futures market but, whichever you choose, taking advantage of a headline-driven bounce such as we are seeing this morning is a smart move.