Poker players, business negotiators and sales people know and appreciate the value of a good bluff. Just as it is much more fun to win (opposed to being defeated) it is much more fun to dish out a successful bluff than falling for a bluff.
The stock market has been bluffing investors for months now. Novice investors might take solace in the fact that mutual fund managers (supposedly the “pros”) fell for the market's bluff and held a record low of only 3.5% of cash in July 2007. Fund managers were invested to the max right before the market topped and crashed.
Last Thursday (11-20-08), the Dow Jones (AMEX: DIA) reached an intraday low of 7,475 before rallying 13% in two days. This is the Dow’s third short term move in excess of 10% since the middle of October. Monday's 8% correction begs the question if this rally is the real deal (at least a sustainable counter trend rally) or is it just another bluff?
To find out where major benchmarks such as the S&P 500 (AMEX: SPY) and Vanguard Total Stock Market ETF (NYSEarca: VTI) are headed one has to step back and take a look at the bigger picture.
Via our ETF Profit Strategy Newsletter we have alerted subscribers that the Dow will have to fall below 7,500 first before staging a sustainable rally. The forecast of a Dow bottom below 7,500 came over a month ago, at a time when the Dow traded above 9,000.
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The markets have spoken
Reports of a new Treasury secretary (Friday, Nov. 21st) and the announcement of another bailout (Monday, Nov. 24th) for Citigroup (NYSE: C) stalled the market’s slide to lower lows and sparked a rally. Even though the markets only pierced the upper range of our forecast, this bottom looked much better than the previous ones set on October 10th and October 27th.
Unlike October 27th, Thursday (11-20-2008) saw all indexes break and close at new lows. Already on November 14th we wrote: “The Financial Select Sector SPDRs (AMEX: XLF) actually closed beneath its October 27th low. This should serve as a nice foundation for the next push down. A possible target for the S&P 500 is 780.”
The November 19th and 20th Wednesday/Thursday one-two punch created extreme advance-decline readings of 16 to 1 and 13 to 1 (for every one stock up there were 16 and 13 down). This selling pressure caused the S&P 500 to drop 6.1% and 6.7%. Once again, financials lead the charge, followed by mid-caps; iShares Russell 2000 (NYSEarca: IWM) and small caps; iShares Russell 3000 (NYSEarca: IWV) and the Nasdaq (Nasdaq: QQQQ).
For this week, the Nasdaq was off over 8%, small caps over 10%, mid-cap over 11% while the Dow lost “only” 5.3%. Unlike the Russell 1000, 2000 and 3000, the Dow Jones has rather limited exposure to financials (5.61%).
A bottom spotting formula
Spotting a market bottom is not a matter of consulting any one, single indicator. Much more it is a combination of indictors that build a formula or composite sign. Investor sentiment was extremely bearish which indicates an exhaustion of the prevailing down trend. Down-side breadth (as noted above) and volume were significantly higher than usual.
There was no divergence between indexes, ALL indexes closed at new multi-year lows. A bird that walks like a duck and swims like a duck and quacks like a duck is probably a duck. Dow 7,500 probably marked the bottom of this leg down.
Nevertheless, Monday’s 8% drop in the Dow makes you wonder whether this duck might be a goose or some other feathery creature. Not only was Monday’s sell-off deep in percentage terms, it was broad in scope. Out of the 500 S&P 500 stocks, only one was up. Over 95% of NYSE volume occurred on the downside.
ETF profit strategies
Investors who followed our advice to go long below Dow 7,500 and S&P 780 are still sitting pretty. If you bought into the market at higher prices (or have been holding for a while), consider implementing hedges to protect your portfolio from further drops. This strategy won't make you (much) money but it will prevent you from losing the farm.
If you want to hedge your entire portfolio, consider broad short ETFs such as the ProShares Ultra S&P 500 (NYSEarca: SDS). If you want to hedge specific sectors of your portfolio, consider short sector ETFs. For example, if you are heavily weighted in technology, consider the ProShares UltraShort Technology (NYSEarca: REW).
ProShares is not the only one to offer short ETFs. Rydex offers a suite of double leveraged short ETFs. Direxion just came out with a suite of triple leveraged short and long ETFs (read related article here).
Regardless of which short ETFs you add, don’t get too cozy with them. The market will bounce eventually. At that time you don’t want to be caught holding too many leveraged short positions. Set stop losses in both directions.
Start unloading short ETFs in stages as the Dow moves closer to 7,500 again. For example, unload 1/3 if the Dow falls below 7,800, the next third if the Dow falls below 7,500 and the final third if the Dow drops even further. Do the same if the Dow moves into the other direction, past 8,400 again. You could consider this; "dollar-cost averaging hedging."
Ideally, don’t put yourself into an “investment pickle” to begin with. With our simple and common sense approach we've been warning subscribers for months. Our ETF Profit Strategy Newsletter offers easy to follow and easy to understand ETF profit strategies along with a general market forecast. We don’t do magic, but our common sense approach has saved investors a lot of headache and sleepless nights.
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