I’ll admit it.
Like almost everyone else, I’ve been riding the latest bull rally like it wasn’t going to end.
And why wouldn’t I?
The market just took on a global pandemic shutdown – and won.
It took less than five months for stocks to bounce back from a 35% correction, all the while offering the best “buy the dip” opportunity for a swarm of new investors.
People with nothing better to do started putting their money in the market, and we saw stocks rally to new all-time highs.
But all this positive activity painted a rosy picture that wasn’t accurate, and investors began ignoring three massive warning signs.
One warning sign is bad enough.
But a trio of warnings tells us that it’s time to put a hedge in our portfolio and prepare for the worst.
Fortunately, protecting your wealth from current bearish patterns is as simple as buying one stock…
Bearish Warning Sign #1: The “Risk Trade”
As I always say, “the market is driven higher by speculation, not fundamentals,” and this market has been full of speculation.
When thinking about how much speculation was driving the market higher over the last six months, I was reminded of the dot-com bubble.
This is the first time I’m using the word “bubble” in years.
Back in the early 2000’s investors were throwing every dollar they had into the technology space.
Companies like Yahoo, Worldcom and AOL were riding the investing mania to all-time highs.
The problem then, as with any mania moment, is that investors weren’t looking down to check where the markets and reality were.
Instead, investors chased those stocks right off a cliff, and got caught holding the bag when the bubble popped.
It feels like the dot-com stocks have been replaced by cryptocurrencies.
The last few weeks have seen various cryptocurrencies get cut in half which is putting a critical test in front of investors.
Back in the dot-com era, investors kept plowing money into the newly minted tech stocks as if they couldn’t go down.
The same action – not respecting a correction turned bear market – will be the first sign that you need to protect yourself from a 20% decline in stocks.
The next two weeks price activity in cryptocurrencies will serve as a “canary in the coalmine” to tell you if it’s time to take an even more defensive posture towards stocks.
If it drops any further, the stock market may behave similarly, which is why I’ll walk you through with an update each week.
The earnings reports aren’t painting a pretty picture for the stock market, which leads me to our second warning sign.
Bearish Warning Sign #2: The Earnings Picture
Historically, the market hits a long-term top and starts a corrective phase after earnings on the S&P 500 peak (usually over 15%% growth).
Keep that in mind as you read a few stats from financial data firm, FactSet…
“For Q1 2021 (with 95% of the companies in the S&P 500 reporting actual results), 86% of S&P 500 companies have reported a positive EPS surprise and 76% of S&P 500 companies have reported a positive revenue surprise. If 86% is the final percentage, it will mark the highest percentage of S&P 500 companies reporting a positive EPS surprise since FactSet began tracking this metric in 2008.”
This quarter’s earnings season knocked the cover off the ball, in more ways than one.
The 86% rate matches 2008 (just as the market top was forming) while earnings growth hit 51.9%.
To put that into perspective, the growth rate was 55% coming out of the Great Recession.
In both cases, the market was rebounding from a correction, but in only one – the Great Recession – had the market actually gone through an economic contraction.
Economies contract, and this economy hasn’t contracted in more than a decade.
Unfortunately, that means that its due for one, even though earnings look good in comparison to a year ago.
Another data point that stood out to me from FactSet’s research was that only 54 companies in the S&P 500 issued positive guidance during this earnings season. In 2010 this number was much higher.
All these financial stats lead me to our third warning sign, and this is one warning we must never ignore.
Bearish Warning Sign #3: The Technicals
Technicals ALWAYS matter.
Price action – and more importantly its trends – is the only true way to get a read on reality in the market. Here’s what the technicals are saying.
S&P 500
We’re still in an intermediate-term trend at the broad market level. The S&P 500’s 50-day moving average continues its ascent higher, which almost always indicates that the market is going to continue its trek higher.
The 20-day moving average has started to indicate that the traders are pulling back from the highs. In other words, they are taking profits as stocks nudge higher at a slower pace.
Bottom line here is that these two trends suggest that we truly are moving into a bearish market and investors should start to eye some additional hedges for their portfolio.
Nasdaq Composite
This is where things get a little shaky.
The technology sector has been trading in a range for the entire year. The Nasdaq Composite has been unable to break to new highs like the S&P 500 which is some cause for increased concern.
Looking at the chart, the Nasdaq’s 50-day moving average lacks a trend and is now acting as resistance. That alone tells you to start cutting back on exposure in riskier assets and to start hedging your portfolio for a bumpy ride.
Russell 2000 Index (NYSE: IWM)
Remember what I said about the risk trade? The IWM is echoing the message that we’re seeing from cryptocurrencies.
The IWM has been trading below its key trendlines since early March and the small cap index’s 50-day moving average is now in a bearish trend. The fact that investors are backing away from small cap stocks is an indication that the “safety trade” is all that is holding the market up. What I mean by the safety trade is industrial, value and other lower-risk sectors of the market.
These situations rarely play into the hands of higher prices, which means that the real safety trade is to add a little protection to your portfolio.
Buy This Stock to Hedge Your Portfolio Now
One hedge that I am adding to my personal accounts is the Proshares Ultrapro Short Russell 2000 ETF (NYSE: SRTY).
This exchange-traded fund (ETF) trades inverse to the IWM by a factor of three. In other words, the ETF goes up 3% for every 1% drop in the small cap index.
I’m adding this position to a few of my accounts as a hedge given the fact that the IWM is already trading in troubled waters with its 50-day moving average in a bearish trend.
I’m expecting another 10-20%% decline in the IWM over the next few months if the current trend continues, which means that my hedge in the SRTY shares may appreciate by 50-60%.
I always remind investors that this is a more aggressive hedge than just selling to generate cash or implementing a trailing stop strategy in your portfolio, so make sure that you are not over-purchasing this hedge.
Whether stocks head towards bull territory or bear territory, we can make money regardless.
As the world transitions back to normal, the market is blindsiding investors with unpredictable movements, and I’ve got my eyes open for any trends we can take advantage of.
Stay tuned for my next Straight-Up Profits article to stay up-to-date with all the different ways to play the current market.
Until then,
— Chris Johnson
Source: Straight Up Profits