The recent rally is looking very long in the tooth. Factors such as:
- Overbought momentum indicators (see RSI, Stochastics on chart above).
- Sentiment readings are becoming overbought (Rydex beta ratio shows a big flow into high beta funds and out of lower beta funds, put/call ratios are toying with high levels, “smart money/dumb money” studies show odd lot and speculators are moving into the market, etc).
- The first level resistance on the S&P 500 at just over 1420 is just around the corner
- Dow transports were, at least up until very recently, diverging (underperforming) the industrials—see chart below
- Low volume means low conviction to the current rally
- An uninspiring recent earnings season
- Seasonality for markets is weak in September and early October, plus electoral patterns for weakness from September to November in an election year
It is my opinion that the current rally, which I did play, is based on the possibility of Federal Reserve monetary stimulation. Based on past patterns, stimulus programs by the Fed have not been implemented in September, so the market may be in for some disappointment if participants are counting on a Fed-based rally. The last stimulus programs were introduced in November 2008 (QE1), November 2010 (QE2), and October 2011 (Operation Twist). This is one more reason why I believe the current rally won’t last – markets are betting on stimulus happening sooner than it might actually occur. As an aside, recently I heard a talking head on the radio call the summer rally on the US markets a “melt up”. This term is one of those newly popular cliché’s that tend to become popular in business circles. Business people use them in an attempt to sound witty or intelligent. I’d like to motion a bill to punish those who make up or use these annoying terms.
How to hedge your risk
The obvious way to hedge risk out of an equity portfolio is to reduce your equity exposure. You can do this by selling your most vulnerable positions (technically weaker) and raising cash. The other way to reduce risk is to hedge it out with a “neutralizing” strategy. This can involve buying an element of an inverse ETF’s for the portfolio, or buying securities that might actually benefit from a market decline (treasury bonds, short positions, etc).
I was on BNN’s Market Call show last Friday, where I presented a unique ETF for hedging equity portfolio risk. I’d encourage you to view the show—particularly the final segment where I present my current top picks to learn more about this hedging strategy. I’d also be interested in hearing about hedging techniques that readers are using or have used successfully in the past to reduce portfolio risk.
On a final note, I am on BNN again for a quick morning commentary with Frances Horodelski on Thursday at 10:30 AM. I’m not sure what I’ll cover at that point, so let’s just say I’ll address the markets from the perspective of the market currents at that time.