Sheltering From The Rain: Hedging The S&P 500 With The VIX

| About: iPath S&P (VXX)

As we are in the midst of the S&P 500 Rainy Season, investors are now seeking shelter. One particular instrument that may be useful is (NYSEARCA:VXX). At current prices, expectations are for this ETF to increase by over 18% in the next couple of months as the S&P 500 declines by up to 10 percent to the 1,500 price level.

Reasons for bad weather

Since the beginning of the year the Fed has been signaling to the capital markets via FOMC statements, FOMC minutes and even speeches, the need to reduce or "taper" its QE program and return to standard monetary policy. The bond market has been most sensitive to these signals as both the 10-Year and 30-Year U.S. Treasury indices hit their 1-Year highs of 2.93% and 3.94% respectively. The charts below show the U.S. 10-Year and U.S. 30-Year yields over the past year.

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These positive moves in rates are sure to increase borrowing costs for both households and firms. This move can lead to a reduction in demand for investments in the U.S. One such example is the demand for new houses. Although this may be the first negative sign for the year in the housing market, the percentage change is quite significant and is in line with rising long term yields. Purchases of new homes fell 13.4% in July, the most in over 3 years. Expectations are for this crimping in demand to permeate through other U.S. markets, including equities.

Besides the seasonality factor in stocks which was articulated in my previous article, there also appears to be other valuation metrics that can attribute to the deterioration of the U.S. equity markets, as indexed by the S&P 500. Over the past month the P/E valuations on the S&P 500 index peaked at the 1-Year and 3-Year price levels. The S&P 500 P/E high stood at 16.44 times above the 1-Year average of 15.00 times and the 3-Year average of 14.47 times. The charts below show the 1-Year and 3-Year P/E of the S&P 500.

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Investors should note that while the overall S&P 500 P/E is expected to continue upwards in the medium term, the rate of share price increase appears to have surpassed earnings growth levels. This overvaluation is a cause for concern as we are already in the rainy season. Investors should anticipate a reversion to the mean not by earnings growth, but rather price decline.

Investors can also utilize comparative analysis to formulate a view of risk aversion in the equity markets. By hedging the ETF (NYSEARCA:SPY) with the ETF (NYSEARCA:IEF), investors can create a Stocks vs. Bonds instrument, as seen below.

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While the trend above shows that stocks have been outperforming bonds over the past year, the price of SPY/IEF appears overbought, coincidentally around the same time the S&P 500 Index's P/E made a new 52-week high. Furthermore SPY/IEF is testing its 1-month moving average. If SPY/IEF were to fall below, and trade under, its 1-month moving average along with the respective RSI level priced below the 50 level, investors can conclude that bonds are favored over stocks in the short to medium term. This is, in my opinion, a risk aversion signal.

Umbrellas, Raincoats & Galoshes

In preparation for this precipitation in the U.S. equity markets 2 ideas come to mind:

1. Shorting SPY - Investors should consider shorting SPY to hedge their equity portfolio. The S&P 500 made a 52-week high of 1,708.96 in mid August but there appears to be some bearish divergence in momentum. Expectations are for the S&P 500 to decline to the 1,500 price level. The chart below shows the daily price movement of the S&P 500.

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2. Buying VXX - Equity declines tend to lead to an increase in value in the VIX. Investors can take advantage of these price moves. As seen below, VXX has a -2.40 beta versus SPY over the past year so investors should purchase $40 in VXX for every $1000 of their equity portfolio for an effective hedge.

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The chart below shows the ETF VXX . Investors should monitor this ETF and purchase when it crosses above its 1-month moving average, its MACD is positive and its RSI is above the 50 level. The target price for VXX is above the major resistance level at $18.

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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.

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