Those of us who watched the Denver Broncos win the Super Bowl on Sunday were reminded that defense wins championships. The same can be said for a well-rounded portfolio.
More than a month into the New Year, and the S&P 500 continues its technically driven course. And for now, there are a number of indications that things are going to get worse before they get better.
That’s right, the S&P 500 and other benchmark indices continue to flash relatively clear signs that the market is going to press to new lows. One major reason is that the trends have been clear in identifying that investors are taking any opportunity to sell into strength.
The following are three bearish telltales of this market …
#1: The S&P 500 Breaks Key Support (Again)
Click to Enlarge The market’s benchmark index sent the first shot across the bow way back in September when it posted a second consecutive close below its 20-month moving average. This trendline is seen by the technical community as the line of demarcation between bull and bear markets.
The last time that the market saw two consecutive closes below this key trendline was January 2008.
As of January’s close, the S&P 500 has repeated this intermediate- to long-term bearish signal, which should have investors shopping for defense.
The S&P 500’s Trend Reversal
Click to Enlarge Following the breaks below the bear market trend, the S&P 500 has now seen a bearish cross under its long-term trendlines, specifically the 10-month moving average crossing under the 20-month.
Since 1973, there have only been nine instances of this long-term bearish development, meaning that the market should be paying attention. The last instance of this “signal” was in May 2008 — a signal that was followed by a near-halving of the S&P 500!
There’s no surprise that this bearish cross-under is happening five months after the initial break into bear market territory, following the exact same pattern of the May 2008 signal.
This indication suggests that the market is likely to trend lower with increased volatility as investors begin to give up hope that the market really isn’t broken and follow that up by selling until the dust clears.
The Fear Index Isn’t Showing Fear!
Click to Enlarge Market bottoms, both long- and short-term, are always marked by an excessive spike in investor fear as everyone runs for the door at the same time. This, of course, serves as the foundation for the rule, “The best time to buy is when everyone is selling.”
Recent activity in the CBOE Volatility Index, or the VIX, while elevated, is far from the levels that will mark the long-term buying opportunity for the current market.
Consider the fact that the S&P 500 is currently trading below its summer lows while the VIX is still trading about 50% lower than the highs it saw during the market’s summer lows. This is a clear sign that investors are complacent, despite the deepening losses.
Bottom line on the VIX is that we will see readings above 50 or 60 before this long-term trend starts to show signs of reversing. So hold on — Wall Street’s wild ride is far from being over.
So, now that we’ve gotten that out of the way …
Here’s how to prepare your portfolio for lower prices and higher volatility.
Defensive Play #1: Raise Cash
If you’re looking to keep it simple, then the easiest defense is to simply raise cash by taking profits — and yes, in some cases, taking losses.
Many mutual fund managers don’t have the luxury of stashing cash away in their portfolios, but you do.
Think of your cash balance as a rainy day fund for your portfolio, you want to have it around when it’s raining the hardest. Given the current trends, a 30% to 50% cash holding is not unreasonable for investors looking to sidestep lower prices and volatility.
Defensive Play #2: ProShares Short S&P500 ETF (SH)
One of the simplest hedges against a declining market is the ProShares Short S&P500 ETF (SH). This ETF goes up 1% for every 1% decline in the S&P 500, on a daily basis. If you want to “hedge” 20% of your portfolio value, then simply invest 20% of a portfolio in the SH shares.
One warning: Monitor a hedge like this closely so you don’t exit the hedge position long after everyone else has. Always have an exit strategy with a hedge.
Defensive Play #3: iPath S&P 500 VIX Short Term Futures ETN (VXX)
We mentioned that the VIX is going to spike higher before the market finds a bottom. Well, the iPath S&P 500 VIX Short Term Futures ETN (VXX) offers an opportunity to benefit from the spike in fear when investors run for the door.
With the VXX trading at $28.25 right now, we expect that the exchange-traded note will break above its summer highs of $31.48, with a likely target of $36 before the market forms a tradable bottom.
Given our price target, the VXX shares have the potential to rack up a 25% gain on the eminent volatility spike, offering another option for those looking to hedge their portfolios.
Again, a warning: Like the SH shares, you can miss the opportunity to close out this hedge with profits if you don’t have a plan. Monitor this hedge closely and have an exit plan.
As of this writing, Johnson Research Group did not hold a position in any of the aforementioned securities.