The Fed To Trigger A Large Correction? Profit On The Panic

by: Christopher F. Davis

Stocks have had strong gains for six months straight after dipping in November. We are now in the longest stretch in over 7 years without a correction of 5% or more. This cannot go on forever, even with the Federal Reserve having its pedal to the medal. In fact, as soon as there is a confirmed indication that the Fed will pull its foot off the gas to reduce its massive third round of quantitative easing, aka QE3, big money will likely hit the sell button. Just this morning (5/20/13) the Dallas Fed President stated that it is not a matter of "if" they will dial back the easing, but "when" and how much. In fact, Fisher stated that halting it altogether will be "too violent for the market."

I do not know how or when they will begin to dial back, but we are overdue for a correction. I think the market will be looking for an excuse to sell off. Perhaps the Fed will end the Operation Twist replacement debt-buying program, where they are spending another $40 billion to $45 billion a month in balance sheet expansion. Ben Bernanke is on record about his concerns with the efficacy of the Feds continued monthly asset purchases. Unwinding such large positions could take a toll on markets. While the Fed has been buying, the action has been phenomenal for stocks and terrible for gold. With investors watching and listening to the Fed's every word, we know that big money is just waiting for a sign that the party is over. Currently, the Dow is now at 15,300 and the S&P 500 is at 1657. At the time of this writing the markets are still pressing against setting all time highs. With the euphoria in the markets, the Dow Jones ETF (NYSEARCA:DIA) is at all time highs of $152.72 and SPDR S&P 500 ETF (NYSEARCA:SPY) printing at $166.36, it would be prudent to be prepared for a fast and quick selloff. When it starts, it could be quick and volatile. It may not be today, it may not be tomorrow, but the Fed will eventually take its foot off the gas, causing selling.

I recommend watching closely to see what happens and being prepared. It may be a good idea to lock in a little bit of profit now if you have it. Further, to take some protective action, traders may want to put on some bearish positions. Those who are bearish could consider not only selling stock, but also selling covered calls on their positions, shorting stocks or buying puts. While each of these approaches has its respective benefits and risks, in this article I want to highlight three volatility funds and one leveraged bear fund that could provide great short-term returns in the event of a market sell-off. These funds have performed terribly in 2012 and in 2013 as the market has seen record low volatility and extreme bullish action. If this changes, expect the following funds to provide superb short-term returns.

iPath S&P 500 Short-Term VIX futures ETN (VXX): The Chicago Board Options Exchange Market Volatility Index or the VIX, is a popular measure of the implied volatility of the S&P 500 market index. You may hear it often referred to as the fear gauge or the fear index. The VIX is a measure that is supposed to represent the market's expectation of stock market volatility over the next 30-day period. The VXX is a fund that is one of the better ways to track the VIX (which is not directly available to invest in), in my opinion. This investment seeks to replicate, net of expenses, the S&P 500 VIX Short-Term Futures Total Return Index. The index offers exposure to a daily rolling long position in the first and second month VIX futures contracts and reflects the implied volatility of the S&P 500 index at various points along the volatility forward curve. The index futures roll continuously throughout each month, from the first month VIX futures contract into the second month VIX futures contract. VXX recently underwent a major one-for-four reverse split to increase share value. The fund has an annual expense ratio of 0.89%, is currently trading at $18.27, and has a 52-week trading range of $18.02-$91.52 (please note this range does not account for shares reverse splitting).

VelocityShares Daily 2x VIX ST ETN (TVIX): This is my least favorite, but still effective play on very short-term volatility. The return on this fund is linked to twice the daily performance of the S&P 500 VIX Short-Term Futures. It was designed to provide investors with exposure to one or more maturities of futures contracts on the VIX, which reflects implied volatility of the S&P 500 Index at various points along the volatility forward curve. The calculation of the VIX is based on prices of put and call options on the S&P 500 Index. This fund has a 1.65% expense ratio and currently trades at $2.59 even after undergoing a reverse split. TVIX has a 52-week range of $2.53-$111.80 (note this range does not account for shares reverse splitting).

ProShares Ultra VIX Short-Term Fut ETF (UVXY): This is my favorite play when I expect a short-term volatility spike. The investment fund seeks to replicate (net of expenses) twice the return of the S&P 500 VIX Short-Term Futures index for a single day. The index measures the movements of a combination of VIX futures and is designed to track changes in the expectation for one month in the future. On average, approximately 3.8 million units exchange hands daily. The fund has an expense ratio of 1.41%, currently trades at 5.81 and has a 52-week range of $5.66-$248.70. This wide range has been a result of multiple reverse stock splits conducted by the fund's managers.

Direxion Daily Small Cap Bear 3X Shares (TZA): This is my favorite way to invest in a bear market short term. It is also in the highest risk category given its leveraged nature. TZA management seeks daily investment results of 300% of the inverse of the price performance of the Russell 2000 Index (also known as the small cap index). The Russell 2000 (NYSEARCA:IWM) measures the performance of the small-cap segment of the US equity universe and consists of the smallest 2,000 companies in the Russell 3000 Index, representing approximately 10% of the total market capitalization of the Russell 3000 Index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.

TZA actually does not invest in equity securities or stocks. What TZA does is create short positions by investing at least 80% of its net assets in financial instruments to provide leveraged and unleveraged exposure to the small cap index and the remainder in money market instruments. TZA recently underwent a reverse split, thus it seems to be trading higher than in the past. It now currently trades at $31.15 a share on average daily volume of 6.5 million shares. TZA has a 52-week range of $30.92-$98.64.

Bottom line: There are many approaches investors can take to position accordingly for market panic. While we have had a great bull run in the last few months and the last few years, we have had the longest run in nearly a decade without at least a 5% correction. I suspect markets will indeed begin to drop. The major catalyst could be confirmation that the Fed will cease easing, or begin to taper off. For those who are brave, shorting the SPY or DIA is an option. Buying put options or selling calls on the SPY and DIA is another option for those believing the sell-off is coming. Finally, allocating some funds to the aforementioned bearish funds is an option, as they will perform very well and yield short-term gains in response to the market panic that will ensue if big money managers begin selling when the Fed confirms they will cease purchasing assets.

Disclaimer: I am not recommending investors to be bullish, bearish or neutral. This article is for informational purposes only and highlights approaches one can utilize and funds one can consider in the event or anticipation of short-term volatility and bearishness. It is not a recommendation to buy or sell any of the aforementioned assets.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.