Make The Right Moves When The Fed Stops QE

Includes: PG, VXX
by: Quoth the Raven

All eyes have been on the Federal Reserve over the past few months, as the market surges ahead with one of the biggest and most lucrative bull markets in recent years. It had been reported a couple of weeks ago that the Fed could stop its bond buying quantitative easing as quickly as June of 2013, with many analysts and bloggers speculating the same.

Despite comments made by Jim Cramer last week, I contend that there is a direct correlation between how often and when the Fed injects money into the economy and the state of the global markets. The Federal Reserve has been the ultimate kind of insurance for people looking to go long in the market - essentially an entity that can prevent the market from heading to a recession whenever it wants. No wonder everyone is throwing as much money as they possibly can find into stocks right now; we're betting with the house, and so far in the Keynesian era, the house always seems to win. It almost seems like the perfect crime, and it reminds me of every time as a child when my mother said to me "If something seems too good to be true, it probably is."

It's going to likely be extremely catastrophic when the day comes (in the not-too-distant future, in my opinion) when QE actually ceases to make an effect on the market. That's when we'll have reached the top of the QE parabola, and are going to experience a downside that'll make the housing bubble burst look minor in comparison.

There is no doubt about it - at some point the general public will lose faith in QE, see it as a crutch, and will subject itself to wicked consequences. I've tried to take that concept and put it into one of my patent pending archaic Microsoft Paint examples:

But, for now, we continue to move forward with this bull market. Some people are arguing that this market is going to shake the trend and be able to continue to sustain itself after the Fed stops easing. I couldn't agree less with that concept. Smart money is going to move with the Fed, and will be taking profits and placing their short bets upon the Fed's exit, preparing to do what the professional traders do best: make money when the market is going both up and down. Here's how we've been faring against other bull markets, as of the beginning of January 2013.

- courtesy of InvesTech Research)

Japan has been getting absolutely demolished in the past few weeks, now almost 20% off of its highs.

I've written that I think this signals a coming correction, in my opinion, both globally and in the U.S. I've written several articles lately, claiming the bull market is ending and that it's time to bet on volatility; and it looks like now could be the right time to act on those sentiments.

Some analysts agree with me, with one calling the Nikkei's recent shellacking a shift of seismic proportions:

Yesterday was a tectonic plate shift between the feet of the market...reversal day in the stock market, reversal day in the bond market, very strange movement in the foreign exchange markets. I think yesterday was an extremely important trading session and many many things shifted and changed.

Just last week, the Fed was put under a little more pressure from Alan Greenspan, who made comments suggesting that the Fed should start to back off, regardless of whether or not the economy is ready for it. reported:

Former Federal Reserve Chairman Alan Greenspan, during a Friday appearance on CNBC, struck a nerve when he suggested that central bank intervention actually was holding stocks back from even bigger gains.

While the man known as "The Maestro" stopped short of blaming Fed policy outright, he said "we've got to get moving" in terms of pulling back on easing, which he said likely will create a rise in asset prices.

Now, it's starting to seem like we are closer than ever to the Fed making their exit. This makes it a great time to reconsider some of the investing strategies that you may have been using over the past few years and adjust accordingly to lock in gains and position yourself to make money on a potential market correction.

The first thing I would think about doing is figuring out a calculated strategy to take my gains from unrealized to realized. No doubt that as time has gone by over the past few years, you've accumulated some profitable positions and are either holding onto them for the dividends or because they continue to grow. This is the time to make those positions realized and lock in the profits.

Taking profits is one of my core rules when it comes to investing, as I wrote about in my article "My Definitive 17 Cardinal Rules for Investing Success":

You don't lose money any time you take profits. Read it again : You don't lose money ANY time you take a profit. Novice investors see profit in their account sometimes and proceed to just stare at it, allowing this unrealized gain to sit, gestate, and eventually disintegrate. Too many people wait fruitlessly for their profits in one position to make them their entire fortune. This almost never happens.

No matter what an investor or analyst tells you, we're all guilty of it. Starting out, with no basis in reality, you wait and wait and wait for stocks already in green to make even bigger percentage gains, never pulling the trigger to sell. When you see enough green to meet your preset caveats, pull the trigger and sell. Make your moves with discipline and precision; the investor with a plan makes money while the meek and unplanned are annihilated.

Emotion plays a part here, as I'll discuss later. People sometimes make the mistake of getting attached emotionally to companies, and, while there's sometimes exception to this rule, disciplined traders are cutthroat -- taking profits wherever, whenever, and however they can.

At the very least, take your cost basis off the table if you feel strong about wanting to continue to let positions ride. The only stocks I'd consider letting ride into a bear market would be consumer staples like Proctor & Gamble (NYSE:PG), and stocks with Beta that indicates they in no way move due to what the broader markets are doing. Microcaps are traditionally stocks that do their own thing no matter what the market does, so if you're in a biotech microcap or a green energy stock that's awaiting a catalyst or does not move in correlation to the S&P average - those might be the ones you can hang onto as well. If you're going to hold stocks, it's a great time to think about sector hedges. If you want to hold McDonald's (NYSE:MCD) through a correction, why not hedge by shorting Yum Brands (NYSE:YUM) or Panera (NASDAQ:PNRA)?

In addition, it's a great time to simply go short on stocks that you think are fundamental losers. Even the bull markets have their losers - going short on the losers is a great way to make money. In a bearish pullback, you essentially have two ways to cash in on a short:

1. The company has the fundamental appeal of Donald Trump's hairpiece and, like it, continues to slip and fall based on relative volatility of the underlying entity.

2. The broader market pullback effects all stocks across the board, whether they're fundamentally sound or not, pulling all stock back and bringing value to short positions.

The profits and cost basis that I do lock up, I'd keep in an interest bearing account or something you can roll over until we get to a point where we feel like we have a firm grasp as to which direction the market is heading next. You're protecting your gains, and continuing to let them grow. Bonds, treasuries, certificates of deposits and interest bearing FDIC cash accounts are all great places to put newly made cash.

Many savvy investors were quick to point out the fact that I forgot to mention the long-term contango associated with betting on volatility using ETFs like VXX, so I wanted to make sure that I touch on that here. As I've stated in previous articles, it's just a matter of time before we see an earthquake of volatility again. The Nikkei slaughters of the past month, in my opinion, serve as foreshadowing for me. Using ETNs and ETFs like VXX to play volatility spikes can be extremely lucrative if you invest for the short term. However, holding an ETF like VXX for the long term is almost a guaranteed loser. If the Fed starts to taper, I will take a small short-term position in VXX again for a quick play.

Now, onto gold and silver. I opened up a previous article introducing how I feel about gold and silver:

Prices of both have been hit hard as the Fed continues quantitative easing and retail demand wanes on the heels of analysts left and right downgrading (and in Goldman's case of gold manipulation, immediately covering afterward) the precious metals. I've been contesting for months now that both gold and silver are at great buying spots. I'm very long most precious metals; from a macro view, all non-renewable commodities are attractive long buys for me, gold and silver especially.

The two are well known common inflation and "end of the world" hedges. The metals are both experiencing insane returns over the last 20-year period and are both arguably in the middle of a tremendous long-term bull run. There are tons of arguments out there against gold and silver, as you may have noticed over the past couple of years, but in the long term, as long as we are not heading back to the gold standard, both metals will rise in value correlating with inflation. Most of these bearish arguments, I've found to be from analysts who are making downgrades so that they can buy or cover at lower prices. That's right, welcome to the cesspool world of analyst coverage of markets.

I made some comments about why I like silver instead of gold in a previous article:

Silver is easily the more volatile of the two metals. As silver has many applications in industry, as well as being a hedge for investors, it tends to make sharp moves in both directions. Sharp price moves mean extra risk, but also extra reward if you can time the upward movements correctly. Aside from investors buying silver for the same reasons they buy gold -- primarily an inflation/end of the world type hedge -- silver remains in demand no matter what the current market sentiment is on holding precious metals as insurance.

Gold is the most well known commodity, and as such, is most susceptible to inflation and overbuying in times of panic. Because of this, the gold/silver correlation spread is much larger than it would (or should) normally be. From a buyers stand point, this just means that silver is a better value buy than gold right now.

Also, as long as the Fed continues to keep things warm and fuzzy, a faction of gold holders are going to continue moving their money out of gold and into other investment vehicles. Silver, again, benefits from its use in manufacturing and industry. If the economy continues to churn upward on actual demand, silver is going to stay in demand and will rope the spread with gold back in.

What does this mean if the Fed ends QE? I suggest holding both of these precious metals to some degree in your new "hunkered down" portfolio. I would allocate five to thirty percent here, depending on how conservative your personal taste is.

Through a combination of hedging, taking profits, holding low-beta stocks, and diversifying into some conservative instruments, I feel it's not as hard, as a lot of people are contending that it would be to get your portfolio ready for the state of the economy when the Federal Reserve decides to take the training wheels off.

I'll reiterate that there's an argument (albeit, I think a small one) for the market continuing its bullish sentiments when Bernanke finally decides to pump the brakes. Let's consider what would happen if the unthinkable actually occurred, and you had positioned yourself according to some of the methods in this article:

  • Staple stocks that you've stayed in will continue to rise, offsetting sector shorts (assuming they continue to rise as well).
  • Profits that are off the table and in conservative instruments will continue to eke out gains, although they may not be commensurate with what the market as a whole is yielding.
  • Gold and silver have the biggest chance to continue to suffer in the short term. However, you have a chance to average down on these two metals that are almost guaranteed to rise over the extreme long term.

So there you have it, worst case scenario it seems like you're at less of a chance of losing money as you are simply not making as much of the insane returns as you possibly could. People will scream and complain and argue that any money not made is a loss, but in reality where we try to invest with balance and perspective, that is simply not the case. Remember, absolutely nobody likes being the last person to leave a party. As we await the Fed's next move (they next meet June 18-19), you'll have ample time to make whatever shifts necessary to transition your portfolio to a balance and homeostasis that you feel comfortable and confident with. Best of luck to everyone going forward.

Disclosure: I am long SLV, VXX. 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.

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