Summer is one of the best times of the year here in Southern California when the sky’s clear, the ocean warms up, and the BBQs get hot. However, it is also one of the most volatile times of the year when it comes to the stock market. Over the last month, we have seen the first real signs of risk coming back into the SPDR S&P 500 ETF (SPY), largely due to fears of an economic slowdown if the Fed were to put the brakes on its endless supply of quantitative easing.
Investors must now be concerned with the ability to weather the dual threats of rising interest rates and falling stock prices in an economic environment that has been artificially inflated with cheap money.
One of the ways that we are monitoring the health of the stock market right now is by keeping an eye on the 50-day moving average. This has been a critical level of support for SPY over the last 8 months, which is why a break below that level would be a bearish sign moving forward.
As I have pointed out on the chart above, SPY has regularly come down to test this level and then blasted off to new highs. However, the tenor of the market has seemed to change over the last three weeks as we have seen a decoupling of stock, bond, and commodity prices, which may signal that a broader trend change is in the works.
I have been recommending for several weeks that investors consider paring their stock exposure to prepare for a modest correction. I think that if SPY breaks the 50-day moving average, it could very easily lead to additional downward momentum.
The IMF just released its most recent guidance, which forecasts U.S. domestic growth will be lower than expected, and that higher tax rates along with budget cuts are going to be a headwind for the economy for the remainder of the year. This could ultimately delay a recovery in the labor market, which is one of the key drivers that the Fed is looking at to determine the pace of their quantitative easing efforts. I believe that a stubbornly high unemployment rate will keep the Fed’s zero interest rate policy and bond buying programs intact for the foreseeable future.
In addition, we saw a decline on Friday in the University of Michigan consumer sentiment index for June with a reading of 82.7. In May, this index hit a recovery high of 84.5, which was the highest mark since July 2007. While I don’t think that this one month change is enough data to suggest that consumers are less optimistic, it will be key to watch the trend moving forward to see if the index has topped in May similar to stocks. A lower reading in July will most certainly put investors on edge.
So how do you play this market if you are overweight stocks and looking to preserve capital in the event of a downturn?
I would be looking to establish stop losses in the context of a risk management plan right below the 50-day moving average. This allows you to have some wiggle room in case it touches the trend line and then blasts off, but does not allow you to get caught up in a swift correction. It may also make some sense to pare exposure to highly appreciated positions so you have dry powder to make opportunistic purchases into this dip.
I would not recommend heading for the hills and abandoning all of your stock exposure at this juncture. However, having a game plan in place and understanding the economic risks will allow you to make sound decisions during these summer months. Savvy ETF investors know that using this volatility to your advantage and making proactive changes to your portfolio will allow you to navigate these choppy waters and come out on top a winner.
David Fabian is the Chief Operations Officer and Managing Partner of Fabian Capital Management. to get more investor insights from Fabian Capital, visit their blog here or click here to download their latest special report, The Strategic Approach to Income Investing.