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By Daniel Sckolnik of ETF Periscope
“If you want to conquer fear, don’t sit home and think about it. Go out and get busy.” ~ Dale Carnegie
In the world of finance and investing, oil currently dominates the conversation like the loudest drunk at the bar. And, like that drunk, there is a certain degree of menace that seems to be lurking not too far from the surface.
The Dow Jones Industrial Average (DJIA) had the best day of the year to date last Thursday, yet it was barely enough to enable it to edge into the black for the week. The Dow ended at 12,170, up 0.3% for the week. The S&P 500 Index (SPX) ended Friday at 1,321 for a miniscule 0.1% gain. The Nasdaq Composite Index (COMP) also ended up 0.1%, at 2,785.
Not quite how you would want to end the week after Thursday’s impressive pop. Not, at least, if you were rooting for the Bullish trend that has been in affect over the last six months to continue.
The case may be made that a paradigm shift, from Bullish to Bearish, has recently occurred in the markets, following an extended period of the up-trending variety. And that shift has been thrown into gear courtesy of the turmoil in the Middle East and Northern Africa.
The markets’ most compelling storyline lies with the fact that crude oil closed on Friday at $104.42, the highest level since late in 2008. This hot little number is mainly reflective of the high level of concern over oil supply that has now entered the markets, due to the fact that Egypt and Tunisia have just tossed out their long-entrenched leaders, and that Yemen, Libya, and even Saudi Arabia are currently exhibiting potent levels of systemic eco-political unrest.
So what the markets are now experiencing to a large degree is the manifestation of uncertainty. If the streets of Tripoli go bloody and the Saudi sheiks get shaken up, the ripples in the world economy are likely to get pretty strong and pervasive. It may not happen beyond the current level, but as both the scale and speed of change is happening so quickly, betting on a serene transition of power in the region may be wishful thinking of the more delusional sort.
So where does that leave the small investor? That depends. The best opportunities frequently abound in uncertain markets. However, obviously, so does danger in the form of risk.
If you are a fan of ETFs, you might want to hedge your current virtual portfolio by acquiring a position in oil, in case the uncertainty in the crude supply continues to rise. USO, the United States Oil Fund, tracks the price of crude, though far from perfectly. Should the equity markets tank, an oil position could help buffer that downside move, assuming your virtual portfolio has been leaning Bullish.
Of course, if you feel confident that chaos will reign, you may chose just to bet on oil directionally, going long on USO to accomplish that task, or buying some slightly out-of-the-money calls. Conversely, if you think stability is on the horizon, you can short the ETF or buy puts.
However, there’s another way to hedge your virtual portfolio without utilizing crude futures, oil ETFs or related stocks. It’s a little more complicated, but potentially more profitable.
Most investors and traders have heard of the VIX, the ticker symbol for the Chicago Board Options Exchange Market Volatility Index. It’s a popular measure of the implied volatility of the S&P 500 index options. The VIX is commonly referred to as the fear index, as it is, by its very nature, hyper-responsive to the moods of the markets.
If you look at the VIX over the last six weeks, two occasions can be found where it spiked upwards over 20% in a single day. (The VIX generally goes up when the equity markets fall.) That’s a huge move. It is this fast and deep reverse correlation to the action in the equity markets that make the VIX an ideal hedging tool, if you know how to use it.
If you don’t feel comfortable using VIX futures, you can use VXX (iPath S&P 500 VIX Short Term Futures ETN). It serves as a suitable hedging tool as well, only don’t expect quite the same impact on your virtual portfolio as the VIX. While the VIX spiked up, as mentioned, 20% on those two occasions, VXX responded with a move of around 10%. Not too shabby, though all is relative, and you need to figure out the proportional impact on your own virtual portfolio when constructing these types of hedges.
If you are unclear on the best way to utilize these tools for your virtual portfolio, do some homework. There’s lots of information to be found with a little digging. Of that you can be certain, so have not fear.
What The Periscope Sees
Last week, acknowledging the rising uncertainty in the markets, ETF Periscope looked at hedging your bets via a “pairs” strategy, designed to benefit in either an up or down market. There is a trade-off, of course, as you are sacrificing a certain degree of upside potential for the relative safety of a less volatile trade.
True to the intended nature of the considered trade, the net result was “in the black” for the week, even though the market bounced around like a wayward basketball on a cracked asphalt court. Here’s a review of last week’s pair trades, which, by the way, are still worth considering both from a fundamental and technical perspective.
The Bullish recommendations, XLV in the Healthcare sector and XLK in the Technology sector, remain within the top 5% of Sabrient’s ETFCast Rankings that give priority to sentiment, analyst recommendations and historical performance in both Bullish and Bearish market conditions. On the flip side, IYZ in the Telecommunications sector and XHB in the Homebuilders sector reside in the bottom 5% of the same rankings, and serve as the Bearish choices for this model.
XLV (Health Care Select Sector SPDR Fund) is an exchange-traded mutual fund that invests primarily in the large-cap companies that replicate the performance of companies listed on the S&P Health Care Select Sector Index. Technically, it sits well above its 50-day moving average and is at its highest level since June of ’08.
XLK (Technology Select Sector SPDR Fund) is an exchange-traded fund that seeks to replicate the performance of its virtual portfolio against the Technology Select Sector Index. It remains slightly above its 50-day moving average, which has served as support on several occasions dating back to September of 2010.
IYZ (iShares Dow Jones U.S. Telecommunications Sector Index Fund) is a fund that invests in common stocks of companies that form the Dow Jones U.S. Select Telecommunications Index as per their weighting in the index. It finds itself below its 50-day MA, which is acting like a formidable level of resistance.
XHB (SPDR S&P Homebuilders ETF) is an exchange-traded fund that invests in stocks of companies operating in the homebuilding sector. The fund, before expenses, seeks to replicate as closely as possible the performance of the S&P Homebuilders Select Industry Index. It has bumped up against its 50-day MA for the past week.
Though crude has definitely proved to be rather rude to the equity markets this week, you may chose to be more civil to your own virtual portfolio by hedging your bets with a pair or two of “pairs,”
ETF Periscope
Full disclosure: The author does not personally hold any of the ETFs mentioned in this week’s “What the Periscope Sees.”
Disclaimer: This newsletter is published solely for informational purposes and is not to be construed as advice or a recommendation to specific individuals. Individuals should take into account their personal financial circumstances in acting on any rankings or stock selections provided by Sabrient. Sabrient makes no representations that the techniques used in its rankings or selections will result in or guarantee profits in trading. Trading involves risk, including possible loss of principal and other losses, and past performance is no indication of future results.
