Protect and Profit in Market Corrections

Of late, financial news pundits, known more for their Wall Street grand-standing than their legitimate analysis, have been asking a question they rarely pose; “Are we at or near the top?”  The financial elites like Warren Buffet, Bill Gross and Alan Greenspan are expecting moderate to severe equity market corrections based on a number of factors.  The threats of tapering the bond repurchase programs in lieu of unsustainable quantitative easing, and the potential for interest rates beginning to rise as early as 2015 have big money running to higher ground.  Even in the trenches of money management, polls show that almost 50% of financial experts and advisors now believe the market is overvalued.  Here… have some articles… there are plenty more where that came from with a simple internet search.

 

Three questions come to mind which I’d like to address.
– Are they correct and why?
– If so, what is the best way to seek protection?
– And finally, for the investor who is properly protected, what risks may be acceptable?

 

Are they correct?
**First of all, I want to recommend all my readers subscribe on iTunes or through the website to The McAlvany Weekly Commentary (CLICK HERE).  David McAlvany and Kevin Orrick, along with a cadre of financial experts from around the world have been discussing this very thing for months now.  The show updates each week on Wednesday,  
The sharpest minds in the financial world do not make these predictions lightly, or by gut feeling.  On one hand, short-term traders may approach the ebb and flow of the markets with little concern, perhaps even relish it as opportunity, willing to come in and out of both long and short positions, scalping profits or pattern trading.  However, the more common long-term investor, and the advisors in the industry that counsel them, seek to avoid instability and volatility.  So when these titans of financial industry, who build wealth consistently and intergenerationally speak and ACT in a certain manner, it’s best we pay attention, if for nothing else than to ask why.
Resources like The McAlvany Weekly Commentary, Zero Hedge, Seeking Alpha and others cover this information far more extensively every day than I can in a single article, I will let them retain the honor of educating in those regards.  I would, however like to point out a few interesting aspects of current charts, comparing the Dow, Gold and the US Dollar.
Below is a simple line chart for the Weekly Dow Jones Industrial Average.  Click the graph to enlarge
Aug 5 2014 Blog Post - DJIA 1In this first chart, we see the DJIA dating back to 1998, showing both the market drops from the highs of 2000 to the lows of 2002 and the market highs in 2007 prior to the “crash heard round the world” of 2009.  Fibonacci retracement levels were overlayed on each move, showing market growth just exceeding the 1.382 Fib level in 2007 and beginning it’s descent.  We have currently bounced off of this growth level again as indicated.
Again below is the same chart, but looking at both RSI and Volume.
Aug 5 2014 Blog Post - DJIA 2The 7th rule of Dow Theory states that volume increases in the direction of the primary trend.  More and larger transaction are placed as the price moves the way it’s supposed to.  For more information on Dow Theory (CLICK HERE).  Clearly shown, volume acted naturally in both directions during the rise and fall up until 2003.  From that point on, the Greenspan put was in effect, causing unnatural movement upwards in the market due to fed easing and intervention into the interest rates, but decreasing trade volume against the direction of the market.  Low borrowing rates also means low fixed-income rates, so leveraged positions were taken and massive investments made in riskier assets to chase higher returns.  This resulted in overvaluation of stocks and a correction that extended downwards much further than would have been the case in a market allowed to act naturally.  Like the childhood adage of, “the bigger they are, the harder they fall,” the market moved higher than it was supposed to, so the crash was harder that it should have been.  In this writers opinion, this is rather ironic in a Keyensian Economic System in which central bank intervention exists to smooth out the highs and the lows.  In this instance, supposed Keynesian Economics exacerbated the problem.
Likewise in this chart, I also note a couple simple, but interested aspects of the Relative Strength Indicator.  RSI is my closest friend when trading the secondary and tertiary trends.  It is a simple indicator, but can be very complex in analysis.  If you would like to learn more, I recommend picking up the book RSI: The Complete Guide by John Hayden.  While there are many things RSI can tell us on this chart, a simple concept noted on the chart is the ability or failure of a market to maintain a trend by pushing the relative strength index above or below certain levels.  In the previous rise that ended in 2007, RSI was unable to confirm the bullish trend multiple times before one final push upwards.  The crash followed.  We have seen this event repeated recently.
Among the slew of economic data available and a number of charting factors, including the few mentioned here, let’s agree to the assumption that a moderate to sever market correction is indeed pending, possibly beginning.  This brings us to our next question, “If they are right, what is the best way to protect ourselves.”
The immediate assumption for most is a move to short-term US Treasuries.  Below is a chart of the US Dollar Index overlayed on our previous DJIA.
Aug 5 2014 Blog Post - USD-DJIA 1
Going back to the tech stock boom and bust of the late 1990’s to early 2000’s, you can see as the US Dollar Index began a steep climb nearing the end of the tech stock bubble, rising almost 33% during the final months of the market’s rise, and first part of the markets fall.  It is a reasonable assumption that when the equity market is nearing, or has passed through the top, many begin the rush to liquidity to preserve the gains they may have made, and the savvy to prepare for opportunity.
As those opportunities presented themselves, coupled with the Greenspan Economics maintaining artificially low interest rates, investors began dumping their dollars again during the final stages of the fall and subsequent rise.  During the period where both the equities and currency fall, it can be argued this is due to wealth loss, economic contractions and unwinding of leveraged positions and margin calls.  Investor sentiment declines both domestically and internationally, and interest in US markets wane.  Through the Greenspan era we witnessed similar opportunity.  Interest rates were held artificially low, investors were encouraged to shift focus to borrowing instead of fixed assets, and we saw the subsequent boom in both equities and especially the real estate market.  Standard boom and bust cycle followed.
What Provides Protection?
In the initial tech stock bust, currency depreciating dramatically along side the equities, especially in the latter months.  A US Dollar position would have provided protection during the initial correction phase.  However, the mania which followed combined with Greenspan economic policy, caused near as much downside pressure on the US Dollar as the losses would have been by remaining in equities.  Sure, you’re $100 cash would have still been $100 cash, but it’s purchasing power back into the market would also have diminished, netting little, if any opportunity to re-enter with minimized losses or maximized opportunity.
During the real estate boom-bust era, we saw a slightly different story.  While the US Dollar diminished in value during the first stages of the collapse, it did find bottom earlier than the equities.  I would argue this is due to a large investor population taking their initial licks and starting to get out as the equities tumbled.  That “fire sale” panic inevitably shoved the US Dollar higher as the equities reached bottom.  In this instance, exiting equities to cash at the peak of the equities market would not have given you the best possible entry point for the dollar, but would have exchanged potential massive losses for minor ones.  Exiting halfway through the market collapse would have gotten you into the dollar at the best possible levels, but you would have already sustained at least moderate losses in equities during the initial months of the fall.  Six of one, half-dozen of the other.
So all this being said, at least over the last 15 to 20 years, there is no way to guarantee that a rush to cash will negate all potential losses.  You can avoid some, but not all.  You can reap some rewards, but not all.  A little math can tell us exactly what day would have been the best exit point, but even the best isn’t perfect and marginal losses in either equity value or purchasing power would still have been felt.
So what to do?  Perhaps another asset provides opportunity.  Below I have added another asset to our chart, gold.
Aug 5 2014 Blog Post - DJIA-Gold
The gold market took a tumble along side the equities market, from a high of just over $1032 per ounce to lows under $700 per ounce.  However, what is most interesting is that the precious metals market ran the entire cycle and exceeded the pre-crash high within a year and a half, and then went on to near double that price before our recent correction.  The equity market took over 5 years to accomplish just the first step of recovering from losses, and I think seeing the Dow near double to 28,000 seems rather unlikely at this point.  As investors fled from equities at any cost and flooded into cash or equivalents, they sought alternative investments.  This caused the boom in gold over the subsequent years.
While many will point out that gold has corrected from its near $2000 high, it currently sits 27% above $1032 level set prior to the crash in 2008-09.  The Dow, which has yet to have any correction is only 14.5% above its pre-crash high.
So there we have it, examples of how no single asset class or strategy can provide “perfect” opportunity.  My recommendation then is in line with what we call the Perspective Triangle and I would encourage you to watch the following YouTube video for explanation (CLICK HERE).
First, you want to hold a substantial commodities position.  Most of us do not have a balance sheet akin to Warren Buffet and can’t afford to buy the Burlington Northern Railroad.  Instead, physical precious metals are the best bet as a preservative hedge.  I emphasize the word physical, as futures contracts and ETF’s fit a different category, are paper promises, often leveraged investments and carry risk that does not exist when owning something outright.  This represents a preservative hedge to counteract not just your individual financial losses, but the greater economic concerns.  This would include the periods of time represented in the charts above as when both the equities and underlying currency are falling simultaneously.
Second, a cash position held for two reasons; to potentially counter losses and provide liquidity for entry opportunity as the market nears bottom.  This can include short-term treasuries for moderate percentage gain, or just a checking, savings, CD or money market account.  If you have the opportunity, it may be appropriate to diversify into additional currencies, but please note we are discussing protection from losses FIRST, and potential gains later.  FOREX or other speculative currency investments DO NOT apply to this category of money.
Finally an investment position, which we will discuss further in a moment.
Regarding your gold and cash.  As mentioned above, the futures and ETF markets can cause gold and other commodities to post some losses alongside the equity sell off.  When margin calls must be met, good assets have to be liquidated to cover the losses taken on bad assets.  But as investors panic out of equities into cash, and then seek alternative investments, commodities by nature provide that sigh of relief, and witnessed substantial gain above and beyond their main goal of providing stable purchasing power, as proven through previous crises.
OK, I’m property protected in a healthy mix of physical commodities and currency, what about the third side of that triangle, growth?
It’s a good question, in reality why bother investing at all if gain isn’t at least part of the conversation?  Inevitably that is the goal for the cash position, to reenter the markets at depressed prices.  To invest in nothing for short periods of time can be part of a sound investment strategy.  But opportunity can exist during a crash, not just after.  My encouragement for most is to focus primarily on preservation and liquidity at this point.  For the more aggressive investor, small percentages of your portfolio can be earmarked back into the equities.  First, small positions with a short-term mindset can still be considered for certain industries and equities.  At the time of this writing, I do personally hold some small, long positions in a few carefully selected equities.  I emphasize the word “small.”  If the shares I own went to $0 tomorrow, I could easily shrug those losses off.  Another option which I will discuss further this fall is considering taking short positions against the US equity markets.  I encourage all readers to discuss with a financial professional at length the dangers of short-selling, inverse-ETF, and other options prior to exploring these avenues. The more lucrative an opportunity may seem, the more damage it has the potential to cause.

As always, if you have questions, feel free to contact me using the form below.

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