Goldman Sachs recently announced that they believe the stock market is poised for at least a short-term sell-off. Bearish calls from major Wall Street firms are rare, so it makes sense to pay attention to this news.
In addition to Goldman’s change of heart, I have a few other reasons to be concerned about the short-term. Here are a couple ideas for where to put investment capital while the risks are high.
In March of this year, Goldman Sachs said they believed stocks were undervalued and over the next few years stocks would deliver strong gains. Three months later, strategists at the firm said the S&P 500 could fall towards 1,285 from a recent 1,350.
Stocks have gone down slightly in the past three months while the economy has shown signs of deterioration.
This is a setup for a bear market.
To spot investment opportunities, I like to look at the 26-week Rate of Change (“ROC”) indicator.
This indicator points to promising stocks and ETFs that have real potential to outperform the market.
It also points out the stocks and ETFs that are most likely to underperform. I’ve found the same general idea can be applied to economic data as well.
Oil prices are a reliable indicator of economic growth. While many analysts claim that price spikes in oil are the cause of recessions, the reality seems to be the price spike represents an overheated global economy. The recession begins after the price of oil falls.
This is shown in the chart below, which show that when oil gains at least 80 percent in a year, a recession follows the peak. That’s where we are now.
The biggest problem with this type of analysis is that there are few data points. Oil has only gained more than 80% in a year five times since World War II. But combined with other economic data, it looks like we have a good chance of a recession soon and stock prices generally fall in a recession. Risk is certainly high in the stock market right now, and traders should consider where they can turn for safety.
Goldman may be conservative with their downside estimate of 5%. Stocks fell more than 45% in six months during the last recession which was triggered by a global debt market crisis. With another global debt market crisis possible, a sell-off could go significantly lower than Goldman’s target.
Some traders may be attracted to low volatility ETFs as a way to ride out a potential market dip. This is a new type of ETF that buys the least volatile stocks in an index. While these ETFs are likely to lose less than the general market averages, they are likely to lose in a bear market where almost every stock declines.
Another option is volatility itself as a potential trade. This trade makes sense for only the most aggressive traders. Volatility can be bought and sold with the VIX Index in the futures market or as an ETF. The VIX Index is sometimes called the “fear index” — traders tend to sell wildly as stocks fall and volatility increases with this selling. The index is actually calculated from the volatility priced into options contracts on the S&P 500. Other volatility indexes are available for other indexes.
VIX tends to move up by about 5% for each 1% decline in the S&P 500, on a daily basis. There are futures and options based on the VIX and ETNs can also be used to trade volatility.
The VIX index, and tradable securities based on it, move significantly on days when stocks make big down move, and a quick up move in stocks could wipe out trading gains. That makes this best suited for those willing to closely follow the market.
iPath S&P 500 VIX Short-Term Futures ETN (VXX) and iPath S&P 500 VIX Long-Term Futures ETN (VXZ) are ETNs that traders can use to hedge against a market decline. VXX generally moves about 75% as much as the VIX, and VXZ moves less half as much as the VIX, on average. A small position in one of these ETFs could be an effective hedge for traders worried about a decline.
Theoretically, if the market falls by 10%, VIX could rise by up to 50%. ETF traders could enjoy gains of 20-40% on their positions. If you buy one of these ETFs, it is a good idea to have a sell rule in mind and maybe exit when the VIX closes above its 10-day moving average for example.
In reality, these numbers can vary significantly. Over the past 8 weeks, the S&P 500 has fallen about 5%. VIX is up about 24% and VXX and VXZ are both up about 9%. VXX has been much more volatile as the chart below shows.
Trading VXX or VXZ should only be for those willing to accept a great deal of risk. Conservative traders should consider buying ETFs like PIMCO Enhanced Short Maturity Strategy Fund (NYSE: MINT) or Guggenheim Enhanced Short Duration Bond ETF (NYSE: GSY) which have very low risk. These are very low volatility funds that should weather any downturn, but offer little in the way of potential gains other than yields of about 1% for MINT and 0.4% for GSY.
– Michael J. Carr
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Source: Trade of the Week