How to Hedge This Crowded Market

Euphoric investors, low VIX might be signaling a crowded market

   
How to Hedge This Crowded Market

The idea of selling when everyone is bullish is a strange concept for many investors. After all, it’s the fact that others are bullish that allows market to go higher.

But when investors begin to get overly optimistic, it’s a sign that danger might be lurking.

Investor sentiment typically leans too far to one side of the market just before a directional change. Participants tend to be too optimistic just before a bearish move and too pessimistic before a bullish move. This is why the best time to buy is when everyone is selling and vice versa.

The reason for this phenomenon is relatively simple: Rising stock prices rely on the availability of cash to move into the market from the sidelines. However, if everyone is bullish, then the majority of cash has already been allocated to stocks.

Euphoria also has a dangerous side. Given that the market is crowded with investors (we often refer to this as a “crowded market”), the potential selling pressure for stocks is higher than normal. A crowded market represents the type of market that investors typically hate: decreased upside and increased downside potential. As an analogy, think of a fire in a crowded theater. When the vast majority of market participants are bullish, the theater (market) is crowded. In this situation, a change in the market’s fundamentals or technicals (fire) will often send the crowd running for the door.

Now that I’ve established the danger of the crowded market, here are two of the best indicators for gauging when a market becomes crowded:

  • Investor poll activity hits bullish extremes. Investors Intelligence readings that show 2.5:1 ratios of bulls to bears (or higher) serve as a caution sign that the market is in a euphoric stage.
  • Low readings of the CBOE Volatility Index (VIX), otherwise known as the “fear gauge.”

Recent activity in both of these sentiment indicators have been flashing warnings signs that investors might have become too optimistic, thus putting us on alert that a “healthy pullback” in stocks is on the short-term horizon.

The most recent Investor’s Intelligence results showed that the ratio of bulls to bears reached 2.6. This is the first time since March 2012 that the bulls outweighed the bears by this large of a margin. Historically, readings of 2.5 or higher usually precede selloffs in stocks. The chart below depicts the relationship between the bulls-to-bears ratio and the S&P 500 during the past year.

Chart11 How to Hedge This Crowded Market

Combined with the low readings of the VIX (nearing its lowest readings in more than a year), the wise short-term investors and traders are positioning themselves for a healthy correction in the market that could shave 5%-10% from current values. Here are two exchange-traded product ideas that can help profit from the pending correction.

ProShares UltraShort S&P500 (NYSE:SDS): Go short the market with this ETF, which provides investors a way to short the S&P 500 with leverage. SDS shares go up roughly 2% for every 1% drop in the SPX. (But note: That also means you could lose 2%, or more, for every 1% improvement in the SPX.) For now, we’re expecting the SPX’s pullback to produce a 3%-5% decline, meaning you could grab upwards of 10% on a short-term portfolio hedge.

iPath S&P 500 VIX Short-Term Futures ETN (NYSE:VXX): Trade market volatility like the professionals do by using this exchange-traded note. VXX shares serve as a proxy for movements in the VIX, meaning that they should climb higher along with the VIX. For now, we’re targeting a move back to $14.75 on the VIX, which represents a 20% spike in volatility. You’re not likely to grab the entire 20%, as the VXX doesn’t move penny-for-penny with the VIX, but the shares will offer a nice hedge against short-term volatility.

As of this writing, Johnson Research Group did not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, http://investorplace.com/2013/02/how-to-hedge-this-crowded-market/.

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