Major Stock Market Sell Off Warning, Investor Defensive Plays
Stock-Markets / Stock Markets 2010 Mar 27, 2010 - 05:00 PM GMT
Mike Burnick writes: Since Bryan is on vacation this week, Martin asked me to pinch-hit as a guest editor today. And it couldn’t come at a better time, because at present, the Weiss Capital Management† investment team is on high alert for a potential market sell-off.
We’ve had a nearly uninterrupted market rally over the past 12 months, but now we believe it’s time to play good defense … and take steps to help protect your gains. Let me explain why …
Naturally, the bulls are quick to point out the 70 percent surge in stocks since the March 2009 lows … they’ll tell you this is a sure sign the economy is recovering … and that we’re back to business as usual.
But don’t believe it! If anything, this rally should give you even more reason to be vigilant right now.
After all, stocks certainly can’t be considered bargains anymore. Based on measures of long-term price-to-earnings ratios, the S&P 500 is as much as 25 percent overvalued now. 1 [Editor's note: To learn more about a Weiss Capital Management strategy that's designed for both bull and bear markets, go here.]
Stocks have gone nowhere but up for over a year, and now they’re trading at expensive valuations, just like in 2007 … and, needless to say, you know what happened next …
Nevertheless, true believers in the recovery continue to ignore valuation while driving share prices even higher. In our view, the rally could come to a crashing end at any time.
What Happens When the Bailout Recovery Ends?
Our biggest concern is that this is not a “normal” recovery at all and our economy remains highly susceptible to a relapse at any time.
The so-called recovery, along with the rally in financial markets, has been largely bought-and-paid-for with taxpayer dollars … with TRILLIONS doled out by Washington for various stimulus and bailout efforts.
- In fact, federal government spending and transfer payments now account for nearly ONE FOURTH of our entire economy! 2
- To put this in perspective, even during the Great Depression — with FDR’s massive New Deal costs — government spending to GDP peaked at just over 10 percent.
- That’s less than HALF of where we are now — with federal spending today closer to 25 percent of GDP! 3
This deficit spending is simply unprecedented and it carries dangerous unintended consequences. Once this government stimulus is withdrawn … what then?
Can the economy — and especially the weak financial sector — sustain a rhythm of growth, without even more massive bailouts? Or, will it be right back to the emergency room for life support?
Only time will tell. But since the government is already winding down support, we may not need to wait much longer to find out what’s next.
Three Key Indicators Forewarn Potential Market Sell-off
Warning Flag #1: Leading Indicators Are Lagging Again: The first cause for concern is a sharp divergence in the indicators that predict the direction of the economy.
Take a look at the index of leading economic indicators, which appears to be clearly rolling over, a sign our economy may be contracting again.
This gauge tends to foreshadow broader moves in the economy.
- It correctly forecast the beginning of the Great Recession in mid-2007 — several months ahead of time.
- This indicator bottomed in late 2008, correctly signaling the bounce back we witnessed last year.
- Now, as the chart above clearly illustrates, the growth rate in the leading indicators has been falling for 10 weeks in a row! 4
This tells me that the recovery may be slowing substantially. Could it be foretelling a double-dip market decline ahead?
To answer that, you need to look closely at stock statistics.
Warning Flag #2: Risky Stocks Leading Rally
Watch which types of stocks are performing best. Indeed since last month’s low, trash has been making investors the most cash lately!
Translation: The riskier, lower-quality stocks seem to be back in favor in recent weeks, leading the market advance.
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Market researchers at Bespoke Investment Group rank the quality of stocks in the S&P 500 based on their market size, valuation and credit ratings. 5
They found that since the recent market lows in early February, investors are walking on the wild side again … favoring poor-quality stocks over more defensive, dividend-paying blue chips.
In many cases, these poor-quality stocks are the same “junk stocks” that led the big market rally in 2009. Small-cap shares — often considered more speculative — are also favored more than blue chips.
- The Russell 2000, a benchmark for small-cap U.S. stocks, is up 15 percent since early February …
- Meanwhile the Dow Industrials, the blue chip index, gained less than HALF as much, or just 7 percent 6…
- Plus, the Russell 2000 is trading at over 50-times trailing earnings now … more than TWICE as expensive as the S&P 500. 7
Of course, there may be perfectly rational reasons why investors prefer small caps over blue chips. For one thing, some analysts believe small caps have stronger profit growth potential.
On the other hand, junk stocks are the same stocks that could prove most vulnerable should the economy relapse into a double-dip recession later this year or next.
Warning Flag #3: Cycle Research Suggests Trouble Ahead
We’re also in the midst of two ominous historical market cycles.
Two of the more popular historic market cycles are the decennial (10-year) market cycle and the quadrennial — or presidential election cycle. This year, we have a convergence of the two, which suggests 2010 may not turn out to be a smooth ride for investors. Consider this …
The decennial cycle indicates that years ending in zero tend to be the absolute worst stock market performers of the decade, at least historically. In fact, from the 1880s through the year 2000, the tenth year of the decade has produced an average LOSS of 7.2 percent annually. 8
At the same time, 2010 is a midterm election year, and according to the presidential cycle, midterm years have posted the second worst performance of the four-year cycle and they have also been turbulent years.
Considering the partisan squabbling coming out of Washington these days, I’m convinced the 2010 midterm election could be especially contentious, adding more uncertainty to the mix as the year goes on.
Since 1930, stock market corrections have averaged nearly 21 percent at some point during midterm years! That’s a sizeable decline … especially when you consider that market declines have so far been relatively mild during the current rally … such as the 8 percent pull back in January and early February. 9
What do these cycles mean? They could indicate a double whammy for markets this year, especially if history repeats itself.
Three Key Steps You Need to Defend Your Portfolio
So, what’s the best way to prepare for potential market volatility ahead?
First, consider paring down your most vulnerable securities holdings — especially if you have profits from this rally. In other words, look at your smallest, most vulnerable stocks carefully. Jettison the riskiest.
Second, consider adding hedges, perhaps using inverse mutual funds or ETFs that short the S&P 500 or the Russell, but stick with single-beta inverse funds only!
That’s because some ETFs should be handled with extreme care, especially the leveraged or inverse funds. These funds don’t always track their index as advertised, and should be monitored carefully. [Editor's note: For more details, see this recent Weiss Advice† article.]
Third, contact your financial advisor to seek professional guidance in turbulent markets.
At Weiss Capital Management, our goal is to grow and protect our clients’ wealth in strong markets and turbulent ones. As a result, these recent trends have us on alert. We have been reducing positions in higher risk investments and raising extra cash in our managed strategies.
Many of our strategies, including the Weiss All Weather Managed Account, have the ability to proactively hedge against a sell-off in either stocks or bonds, using inverse index funds and ETFs.
This strategy is one of several we offer that gives us maximum flexibility in all market conditions … both good and bad. To learn more about this innovative strategy, we’ve put together a special report for you with more details. You can get a free copy here.
Remember: A sudden market plunge of 20 percent or more this summer or sometime this fall would not surprise us at all, but it could prove to be a jarring wake-up call for unsuspecting investors.
Taking proactive risk control measures now within your portfolio may prove valuable in helping protect your wealth during a cycle of more pronounced market turmoil ahead.
Good investing,
Mike Burnick
Director of Research & Client Communications
†Weiss Capital Management (an SEC-Registered Investment Adviser) is a separate but affiliated entity of Weiss Research, the publisher of Money and Markets. Both entities are owned by Weiss Group, LLC.
1 Wall Street Journal: Worries Rebound on Bull’s Birthday, 3/10/09
2 Gluskin Sheff Economic Commentary, 3/1/10
3 Ibid.
4 Gluskin Sheff Economic Commentary, 3/1/10
5 Wall Street Journal: Rally Is a Tale of Wounded Stocks, 3/15/10
6 Ibid.
7 Ibid.
8 Hirsch; Stock Trader’s Almanac, John Wiley & Sons, Inc. 2005
9 Merrill Lynch Market Analysis Comment, 1/5/10
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