Stocks

Insuring Against Further Declines in Stocks

Digital pen on tablet drawing a stock chart
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I know I’m beginning to sound a bit like a broken record, and I have been around long enough to know that history says that predictions of a market drop are usually wrong, but the more I look at the economy, company performance and the stock market, the more convinced I am that all the risk right now is to the downside. That means that I am looking to either sell existing holdings or buy what amounts to an insurance policy, something that will go up in value should the market drop.

You probably don’t need me to give you the reasons that things look a little precarious, but here goes: We are now six months into the coronavirus shutdown, and its impacts are still being felt. Those who assured us that all would be well by the summer were way off, both in terms of the presence of the virus and its economic impact.

Coronavirus daily cases, from Feb - Sept. September is higher than the highs seen in March

New cases in the U.S. are on a downward slope but are still way above the levels reached in the initial spike. Some of that is obviously down to increased testing but according to Johns Hopkins data, the positivity rate is still around five percent, which suggests that at least part of that elevated level is down to some states relaxing restrictions too early.

I know it sounds cynical but is seems that the market is betting that the federal and some state governments will simply accept more cases and deaths as the price that has to be paid for the economy to bounce back. So far, the people in those places have gone along with that, but the longer we go without a vaccine or cure, the less likely that is to continue.

Beyond that, the rapid bounce in stocks just isn’t being matched by a rapid bounce in the economy. Unemployment is lower and falling, but if you had told me six months ago that it would still be above 8% in September, I would have called that a disaster, not a reason to celebrate. There are also increasing signs that a lot of layoffs will be permanent, and new announcements of job cuts seem to hit the wire every day. In short, yes, things are better than they were in March and April, but they are still very far from good.

That is being reflected in corporate profits too. We had an even bigger than usual percentage of beats of analysts’ expectation last quarter, but that is a function of the perennial underestimation of those analysts, not great profitability. In reality, S&P 500 earnings overall fell by over forty percent from a year ago.

And yet, the S&P 500 flirted with all-time highs as that grim story unfolded.

I know and understand the reasons for that. The market is forward-looking, and has to take the trillions of dollars that the Fed is giving them every week and put that money somewhere. However, at some point, there has to be some real economic bounce-back or it will all end in a very messy way.

Chart of S&P 500 challenging its 50-day moving average

From a technical perspective, the S&P 500 is once again challenging its 50-Day MA today which lends some support, but a break of that level could prove to be the catalyst for a big down move. Any bounce, however, is likely to be a grind up, so now looks like a good time to act.

All that being said, the reasons for buying persists, so selling existing holdings has a quite substantial risk to it. A better strategy for most investors may be to hedge their overall portfolio by buying something that will go up if the market does drop, such as the ProShares 3X leveraged Bear S&P 500 ETF, SPXU.

There are two things to say immediately here. First, it is important to look at this as an insurance policy. There is a good chance that you will lose your premium, but in the grand scheme of things, doing so is a positive, in the sense that it's better to lose what you have in SPXU than losing all the potential profits from your holdings, should the market continue to climb. As I've said in the past, it's a psychological move designed to reassure yourself that you are taking action in the event of a market drop, rather than overreacting and making a panicky mistake you'll wind up deeply regretting.

Second, no leveraged ETF is designed for long-term holding, nor is this position. It is to guard against a current risk, so if stocks are still holding up a few weeks from now and things look a little better, you would just take a small loss and count your profits on the rest of your holdings.

With those two things in mind, though, a hedging position in SPXU looks like something for investors to consider.

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

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Markets Economy Coronavirus

Martin Tillier

Martin Tillier spent years working in the Foreign Exchange market, which required an in-depth understanding of both the world’s markets and psychology and techniques of traders. In 2002, Martin left the markets, moved to the U.S., and opened a successful wine store, but the lure of the financial world proved too strong, leading Martin to join a major firm as financial advisor.

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