To seasoned investors, mild market corrections are a welcome event. They put the breaks to investor hype that creates asset bubbles. The trouble is that not every market correction is mild. Some corrections become vicious and prolong leading to crashes that spoil the Wall Street party. What distinguishes mild from severe corrections? What are the warning signs?
Nobody can say for sure, but there is one sign investors should watch in yesterday's correction: It was broad, extending across all major equity and commodity indexes. Precious metals, in particular, were down in a day geopolitical events are heating up (e.g., escalation of North Korea threats to South Korea and the U.S.); and they continue to trade lower on Thursday. Why should investors pay attention to the simultaneously correction of several assets?
Major Precious Metals ETFs / Stocks
Major Equity Indexes on Wednesday
1-day Performance (%)
SPDR S&P 500 Trust (SPY)
Powershares QQQ Trust (QQQ)
SPDR Dow Jones Industrial Average (DIA)
Major Commodity ETFs
1-day Performance (%)
SPDR Gold Shares (GLD)
iShares Silver Trust (SLV)
Market Vector Oil Services (OIH)
Because it parallels the 2007-2008 financial crisis unique, one stands out: The simultaneous decline of almost every asset category. U.S. stocks dropped 37 percent, German stocks 42 percent, and Chinese stocks 62 percent; commodities dropped 37 percent (with oil and copper dropping 54 percent). This means that investors had nowhere to hide, taking multiple hits across their portfolios.
The roots of that broad decline in multiple asset categories can be traced back to the September 2001 Greenspan "put," which lowered the cost of owning different assets. This means that investors didn't have to sell one asset to buy another, as was the case before Greenspan's put went in place. That explains why stocks, commodities, and Treasury bonds rallied simultaneously between 2001 and 2007-though T-bonds usually move in the opposite direction than stocks and commodities.
While helping all asset categories to rally, the Greenspan put had an undesired consequence: it caused a synchronous one-direction move across asset categories, undermining the effectiveness of asset diversification in lowering market risks. In other words, markets were in a "deadly embrace with each other," as Financial Times columnist John Authers puts it in The Fearful Rise of Markets.
That's why the 2007-8 financial crisis was so severe. Once one trade reversed course, others followed, fueling a contagion that broadened and magnified the market correction. Hopefully, history won't repeat itself. What should prudent investors do? How can they protect their portfolios against this prospect?
Use financial derivatives rather than traditional asset diversification to cut markets risks.
Financial derivatives can work like traditional insurance: they shift market risks to somebody else for a fee (premium). Here are two trades to consider: First, buy in or out of money puts on SPDR S&P 500 or SPDR Select Sector Fund - Financials (XLF), which has gained a great deal since the financial crisis. Second, buy volatility, through the purchase of iPath S&P 500 VIX Short Term Fund (VXX) or indirectly through the purchase of Calls on VXX.