Courtesy of John Nyaradi.

As this year’s impressive rally continues, U.S. stock indexes and ETFs are either on track for historic annual gains or are reaching bubble levels with the growing possibility of an approaching blow off top.

At Wednesday’s closing bell, the S&P 500 (NYSEARCA:SPY) and its related ETF were 157 points (or almost 11 percent) above its 200-day moving average.  The only time we have seen a wider gap between the S&P’s 200-day MA and its closing level was back in March of 2000, just before the dot-com crash.  Will history repeat or only rhyme and in Yogi Berra’s famous words, “Are you ready for déjà vu all over again?”

The stock indices cannot keep going up forever (contrary to what you may have been told by your favorite television stock market commentator).  At this point, multiple technical indicators are flashing warnings that markets are overbought and subject to a significant correction.

Beyond the fact that the S&P 500 (NYSEARCA:SPY) is closing at extreme levels above its 50-day and 200-day moving averages, its relative strength index is also near overbought conditions which begin at the threshold of 70.  At Wednesday’s close, the S&P’s RSI had reached 68.58 – although after Thursday’s retreat, the RSI had eased back to 65.54.  Investors respond to these signals which oftentimes make many stock market indicators self-fulfilling prophecies as other investors change their positions based on what they see on current charts.

chart courtesy of StockCharts.com

With the major stock indices at their current levels, investors remain concerned about the consequences of a blow off top and so many have their stops set high to preserve the maximum extent of the extreme gains they have realized so far.  If the stock market swoons, multiple stops will get triggered and a cascade of stop loss orders can quickly lead to a waterfall descent in today’s world of high frequency, computer driven trading.

Overbought conditions exist across all of the U.S. major stock market indexes and so the entire U.S. market is subject to a swift correction should one get underway.

At Wednesday’s closing level of 15,082.62, the Dow Jones Industrial Average was 1,437 points or 10.5 percent above its 200-day moving average.  The Russell 2000 closed at 966.26 on Wednesday which is 101 points or 11.68 percent above its 200-day moving average.  The Financial Select Sector SPDR ETF (NYSEARCA:XLF) closed on Wednesday at $19.17, 15.97 percent above its 200-day moving average.

Such conditions have set the stage for many institutions and hedge funds to try to front run an anticipated decline by taking short positions in futures contracts, shorting stocks or taking positions on inverse ETFs which are designed to gain in value should the stock market swoon in June.

Some examples of inverse ETFs include:

ProShares Short S&P 500 ETF (NYSEARCA:SH) – This ETF is designed to obtain results which represent the inverse (-1x) of the daily performance of the S&P 500. The fund invests in derivatives which ProShares Advisors believes should have similar daily return characteristics as the inverse of the daily return of the S&P 500.

ProShares Short Dow30 ETF (NYSEARCA:DOG) – This ETF is designed to obtain results which represent the inverse (-1x) of the daily performance of the Dow Jones Industrial Average. The fund invests in derivatives which ProShares Advisors believes should have similar daily return characteristics as the inverse of the daily return of the Dow Jones Industrial Average.

Investors with a greater appetite for risk (and return) can use leveraged inverse ETFs, by which their gains (or losses) will be magnified by approximately twice as much as a non-leveraged inverse ETF.

One of the most popular of these is:

ProShares Short Dow30 ETF (NYSEARCA:DXD) – This ETF is designed to obtain results which represent two times the inverse (-2x) of the daily performance of the Dow Jones Industrial Average. The fund invests in derivatives which ProShares Advisors believes should have similar daily return characteristics as two times the inverse (-2x) of the daily return of the Dow Jones Industrial Average.

For the truly daring, there are some leveraged inverse ETFs which will magnify the results by three times.  Two of the largest of these focus on the small cap and financial sectors which tend to be fast movers in falling markets:

Direxion Daily Small Cap Bear 3x Shares (NYSEARCA:TZA) – This ETF is designed to obtain results which represent 300 percent of the inverse of the Russell 2000 Index. The fund creates short positions by investing at least 80 percent of its assets in financial instruments which provide leveraged and unleveraged exposure to the index.
Direxion Daily Financial Bear 3x Shares (FAZ) – This ETF is designed to obtain results which represent 300 percent of the inverse of the Russell 1000 Financial Services Index. The fund, under normal circumstances, creates short positions by investing at least 80 percent of its assets in financial instruments which provide leveraged and unleveraged exposure to the Russell 1000 Financial Services Index.

Bottom line: With markets overbought and fundamental indicators pointing to a global economic slowdown, now could be a good time to consider protecting current positions or making a directional bet with inverse ETFs.  These products, particularly the leveraged class, can be tricky to use, so make sure to read the prospectuses carefully and understand how they work. Take time to plan your strategy for a summer swoon because there’s a good chance that significant opportunities will appear on the “short” side of the market as we head into the “sell in May and go away” period of the year.

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