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Yesterday, I watched the stock market fall because some members of the Federal Reserve wanted to end its quantitative easing (QE) program before hitting its target of 6.5% unemployment. The reason some Federal Reserve members want to end QE early was the risks further QE could have on the economy and inflation. If the Federal Reserve removes or slows down QE, I believe the market could be in for a correction. With the stock market sitting near a five-year high, I believe this would be a prudent time to think about the investment landscape and see what investment options make sense for the possible coming correction. In addition to the removal of QE, there are four other reasons I believe the stock market is due for around a 20% correction.

Reason No. 1: The Stock Market Is Addicted to QE

The drop in the stock market occurring because of the concerns of the Federal Reserve members reminded me of someone who is addicted to painkillers. For someone who is addicted to painkillers, it starts out with having an injury where you need the medication. The injury in this example was the financial crisis and ensuing recession of 2008-09, and the painkillers were QE. The problem is we kept taking painkillers far after our injury healed, and we are now seeing the consequences. Therefore, when someone is addicted to painkillers and goes to rehab, the pills are taken away and withdrawals will occur. In the case of the stock market, the market will decline. In the short to medium term, withdrawals are not good for you. But to not be addicted to something is good for you in the end.

Reason No. 2: Federal Reserve Members' Concerns

I can only see two scenarios in which the Federal Reserve would change its QE policy: if the economy is improving substantially, or the threat of coming inflation. The economy is obviously not improving except at an incremental pace, and a case can be made that inflation is more than the reported CPI. Since President Obama was re-elected on Nov. 6, RBOB gasoline prices have gone from $2.69 to $3.05, or up 13.38% in a little over three months as the chart below shows. The other kind of inflation that is hitting the economy is food inflation, according to the U.S. Department of Agriculture website: "ERS's inflation forecast for both all food and food-at-home (grocery store) prices in 2013 is for increases of 3 to 4 percent." Therefore, when consumers are taking home less money, because of rising costs for transportation and food, they are less likely to spend it on discretionary items.

Click to enlarge images.

Reason No. 3: Dow Theory Lack of Confirmation

The Dow Jones Industrial Average has not confirmed the all-time high that the Dow Jones Transportation Average has made repeatedly over the last two weeks. For the rally in stocks to continue, the DIA has to make an all-time high in concurrence with an all-time high in the IYT.

Reason No. 4: Wal-Mart, the Canary in the Coalmine?

Wal-Mart's (NYSE:WMT) vice president of finance and logistics in a report said, "The worst start to a month I have seen in my ~7 years with the company." The reason for the poor start to the month was the expiration of the payroll tax cut, which makes complete sense because when consumers have less money from their paycheck, combined with higher prices on necessities like food and transportation as outlined above, is anyone really surprised when a retailer says their sales are not that good?

Reason No. 5: Seemingly Never-Ending "Fiscal Cliffs"

There are three "fiscal cliffs" for 2013: sequestration, the continuing resolution, and the debt ceiling.

  • First, the sequestration cliff is on March 1, 2013, and is a series of automatic budget cuts that target primarily the Department of Defense, in addition to other smaller programs. The cuts would have a noticeable effect on the economy and could further hurt the slow recovery.
  • Second, the continuing resolution cliff is on March 27, 2013, and deals with the government being able to fund itself for daily operations. Therefore, if no extension of the continuing resolution is passed, it will lead to the government shutting down.
  • Third, the debt ceiling cliff, which was already kicked down the road to May 19, 2013, and with the treasury using "extraordinary measures" it can put off hitting the debt limit for a month or two after the May deadline. The debt ceiling debate has already caused a major market sell-off in August 2011, and caused a downgrade of the United States credit rating. Can you trust politicians not to do the same thing twice and have history not repeat itself? My guess is no.

S&P 500 Target

I went back and looked at the decline that occurred in 2011 when the debt ceiling debate was going on to see how much the market declined because of the political gridlock. I will use the percent decline from that period to predict target price that I believe the S&P 500 will hit sometime before the end of 2013. To calculate my estimated percent decline, to base my prediction off of, I used the decline from the 2011 high on May 2, 2011, of 1370.58 to the low on Oct. 4, 2011, of 1074.77, which was a correction of -21.58%. Therefore, I then applied that number to today's and yesterday's high of 1530.94 and got a target of 1200.52, which I believe the S&P 500 will hit sometime during the remainder of 2013.

Investment Choices

If my above scenario does occur and stocks have a serious correction, what are some places to "hide out"?

Stocks

If you want exposure to equities and the market is declining, I would go with stable dividend paying sectors like consumer staples (NYSEARCA:XLP), healthcare (NYSEARCA:XLV), or utilities. Another option is to choose a low volatility equity ETF like the PowerShares S&P 500 Low Volatility Portfolio ETF (NYSEARCA:SPLV).

Bonds

If you want exposure to bonds, I would avoid anything U.S.-government-related because of the many "cliffs" listed above. I would go with another high quality bond fund like the iShares Aaa - A Rated Corporate Bond ETF (NYSEARCA:QLTA), which owns only the highest quality corporate bonds.

Gold

If you want exposure to precious metals, I would wait and see if the debt ceiling is extended for the long term. That's because gold prices closely track the level of the debt ceiling as the chart from thereformedbroker.com below shows. Therefore, if the debt ceiling is raised gold should follow the debt ceiling higher. Some options for owning gold are Physical Gold, SPDR Gold Trust ETF (NYSEARCA:GLD), iShares Gold Trust ETF (NYSEARCA:IAU), or ETFS Physical Swiss Gold Trust ETF (NYSEARCA:SGOL).

Commodities

If you want exposure to commodities, I would for sure choose a commodity fund that focuses on agriculture. Every year more and more people need more food, so the demand side of the equation is strong. We saw what happened to the supply side of the agricultural commodity equation this past year with the drought that sent agricultural commodity prices soaring higher. Some possible choices for broad exposure are ETFs like the PowerShares DB Agriculture ETF (NYSEARCA:DBA), iPath DJ-UBS Grains Total Return Sub-Index ETN (NYSEARCA:JJG), iPath DJ-UBS Agriculture Total Return Sub-Index ETN (NYSEARCA:JJA), or a more targeted ETF like the Teucrium Corn ETF (NYSEARCA:CORN).

Hedge

If you want to short the stock market, there are a few non-leveraged ETFs, which allow you to short the stock market. Some possible choices are ProShares Short S&P 500 ETF (NYSEARCA:SH) or the AdvisorShares Ranger Equity Bear ETF (NYSEARCA:HDGE).

Closing Thoughts

Based on the five reasons I laid out above, I think the stock market could be in for a large correction if nothing can be done to tame inflation consumers are seeing, or if politicians continue kicking the can down the road with short-term fixes to fiscal issues. If the three "cliffs" I detailed above cause as much trouble as what occurred in August 2011, we could be in for another downgrade of the U.S. credit rating. I hope I am wrong and the economy does continue upward, but for the reasons I laid out above -- particularly the issues that deal with the government -- the odds the government actually does something that is good common sense seem very slim.

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Source: 5 Reasons The S&P 500 Could Fall 20% By The End Of 2013