Corrections are usually a healthy sign for markets, especially if they are accompanied by asset rotation, whereby investors take profits from assets that had a big run up and plow them back into assets that have been laggards. That's not the case, however, for market corrections whereby investors sell every asset categories, as has been the case in recent market corrections (e.g., April 4th and today).
Major Precious Metals ETFs / Stocks 4/12/13 10.10AM
Major Equity Indexes on Wednesday
1-day Performance (%)
SPDR S&P 500 Trust (NYSEARCA:SPY)
PowerShares QQQ Trust (NASDAQ:QQQ)
SPDR Dow Jones Industrial Average (NYSEARCA:DIA)
Major Commodity ETFs 4/12/13, 101.10AM
1-day Performance (%)
SPDR Gold Shares (NYSEARCA:GLD)
iShares Silver Trust (NYSEARCA:SLV)
Market Vectors Oil Services (NYSEARCA:OIH)
Why is this pattern worrisome? Because it raises the probability of a Black Swan event like the 2007-2008 financial crisis whereby a sharp decline in one asset category was followed by a sharp decline in other asset categories as overextended investors were starving for cash to meet margin calls. The 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.
As we wrote in a previous piece, 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, but the parallels between the Greenspan put and the Bernanke put are too obvious to ignore. 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 (NYSEARCA: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 (NYSEARCA:VXX) or indirectly through the purchase of Calls on VXX.
Disclosure: I am short SLV, GLD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Long QQQ.