The Stock Market’s Red Flags: Four Ways To Handle Potential Market Turmoil

Some people just don’t know when to quit.

A friend of mine is a professional boxer. But he’s 41-years old and his best days are behind him. Nevertheless, he continues to fight. Recently, he was knocked out and I was afraid he got really hurt. Luckily, he was fine, but I sincerely hope he retires, so he can enjoy his family in good health.

Then there’s my five-year-old daughter. Whenever she gets in trouble, she’ll stubbornly argue about her punishment, despite repeated warnings that her “take five” (five minutes in her room with the door closed) is about to increase. “Take fives” routinely become take fifteens and thirties.

Sometimes, investors don’t know when to let it go either. And right now, I’m concerned that many investors might be about to face the same outcome as my friend or my daughter - unnecessary punishment - when it comes to dealing with the stock market’s red flags.

Here’s why…

Technical Trouble

Take a look at the technicals…

• The S&P 500 (^GSPC) climbed by 48% from its low to the recent high of 1,101.
• A retracement of 50% is very common in bear markets - and typically, if stocks can bust through the 50% level, they continue higher.
• But very often, 50% is a ceiling and once stocks approach that level, they head back south again.

For example, here’s a chart of Dow Jones Industrials at the beginning of the bear market that began in 1929, courtesy of Distressed Volatility. Notice the 48% retracement before the market fell again.

To see the chart in its original size, click here.

There are plenty of other technical warning signs, too…

In mid-October, the Dow Jones Transportation Index (DJT) set a double top. When a chart puts in two peaks at equal heights in succession, it’s a strong sign that a top is in place. This is important because Dow Theory, says the Transports must move in the same direction as the Dow Jones Industrials in order to confirm that the move in the Industrials is real.

Giddy Investors and GDP

If it’s fundamentals you’re after, I’ve got those too.

Investors have fallen in love with the stock market’s strong rally off the March lows. And with news last week that the economy is improving, it appears their level of fear has fallen dramatically.

For example, individual investors’ cash levels have fallen to their lowest level since July 2007, according to the American Association of Individual Investors. In July 2007, the S&P 500 was just 21 points away from its eventual top, which was reached just 3 months later.

The bulls and the media gleefully point to the 3.5% rise in third-quarter GDP as a signal that the recession is over. However, while the definition of a recession is two consecutive quarters of negative GDP growth, plenty of recessions have had a quarter or more of positive growth. During the 2000-2001 recession, GDP oscillated between positive and negative for four consecutive quarters.

This gives more support to the theory that the stock market is a forward-looking mechanism. One could argue that the rally over the past eight months was in anticipation of the impressive GDP number that was just posted.

So the big question is, what do you do about it?

Four Ways to Protect Yourself From Downside - And Profit From It

There are a few approaches you can take…

• Put Options: In yesterday’s column, Karim Rahemtulla gave an example of how to hedge against a stock’s downside by buying put options on your existing stock positions through the married put option strategy. It’s an excellent way to hang on to stocks that you like, while protecting yourself from downside.
• Stop-Losses: We also strongly advocate that you set stop-losses on your positions. This is where you enter an order to sell a stock if it reaches a certain price. Sometimes those stops are a percentage beneath the entry, current or high price. Other times the stop is below key support on a chart. But I’ll usually put one in place so the emotion is taken out of my decision making process.
• Inverse Index ETFs: Over the past several years, ETFs have exploded in popularity and you can now buy ones that increase in value if the indexes they represent head go lower. For example, you can  short  Dow Industrials by buying the Short Dow Pro Shares (DOG) or the Nasdaq 100 with the Short QQQ Pro Shares (PSQ). Keep in mind… you’re not shorting the ETFs; you’re buying them. If the Dow or Nasdaq 100 decline by 2%, your position should rise by 2%.
• Inverse Sector ETFs: You can also buy inverse ETFs of specific industries. If you want to play the financial sector downside, you could buy the Short Financials Pro Shares (SEF).

Lastly, you want to adhere to this cardinal rule…

Don’t Be Stubborn

Make sure any short-term trade doesn’t become an investment.

What I mean is that if you’re wrong about a stock, cut it loose and take the small loss before it becomes a big one.

The lesson is this: It’s okay to be wrong in predicting the direction of a stock. Just don’t be more wrong than you have to be. So next time a position goes against you, think of my daughter getting sent to her room for a “take five.” Don’t let your trade become a “take fifteen.”

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