The recent 2.5% pullback in the S&P 500 (SPY) may just be a blip during a year bullish analysts predict the index will finish above 1500. Brief and minor sell-offs have indeed been the market's only hurdles since QE1 began in March 2009 -- the lone exception being early summer 2010, between QE1 and QE2. On the other hand, here are seven reasons U.S. indicies could lose 20% or more in the next two months.
- Conclusion of QE2. Marc Faber, Austrian economist and leading market forecaster, aptly likens fiscal policy to narcotics abuse: Always destructive in the end, though it may have social benefits early on. Over time, however, that benefit requires more and more of the "good" stuff. Americans are no longer net savers and depend, along with every corporation that uses credit or relies on consumer spending, on government jobs and welfare more so than ever before. QE1 supported investment until it was finished. A sell off post-QE2 will be preempted by investors large and small, which may explain recent trading sessions closing in the red.
- Commodities leading down. Commodities markets are smaller and less subject to speculation than stock markets, which is why experienced investors refer to them as leading markets. Oil, silver, sugar, copper and other staples for both consumers and producers have fallen severely in price of late. The selling may still be escalating.
- Uncle Buck is back. Currency markets are also referred to as leaders to stocks. Trading volume is huge, but more driven by governments and billionaires than pension plans and gamblers. The first few weeks of May have witnessed a long-unseen affinity for the U.S. dollar, which has gained 2-5% versus most currencies. This may signal the beginning of a flight to safety.
- Leading stocks looking ugly. From economic bellwethers such as Bank of America (BAC) and KB Homes (KBH) to highly profitable market-changers like Apple (AAPL) and OpenTable (OPEN), downward moves have been drastic. Companies like these are growth-drivers of the economy.
- Defensive stocks outperforming. The best performers lately include utility companies American Water Works (AWK) and Consolidated Edison (ED), consumer staples companies Procter & Gamble (PG) and General Electric (GE), and pharmaceutical conglomerate Pfizer (PFE). Outperformance by stocks that operate low-risk, low-growth businesses indicates defensiveness by investors or an apparent lack of value elsewhere in the market.
- Global growth stifled. In 2009 and 2010, bullish arguments were largely focused on a "good enough" United States and an emerging market boom. With Middle Eastern sociopolitical turmoil taking center stage in that region, Japan in shambles, Europe using Scotch tape to fix budgets, and inflation crippling economies worldwide, from where is growth to come?
- No bottom in sight for U.S. housing. It is one of the largest asset markets, and one that affects everyone, in the world's largest economy. Still, even buyer incentives and suppressed interest rates haven't stopped prices from sliding. A growing population and falling housing prices are basic and clear signs of economic recession.
Investors looking to hedge portfolios or even flip net-short have endless choices thanks to inverse and leveraged ETFs, as well as the opportunity to short individual stocks directly or via options. Betting on increased volatility via VXX will also yield profits if markets sell off. Leveraged ETFs inherently lose value over time and are best for day-traders looking for highly-liquid, diversified ways to capture quick moves.
Directly selling a stock or ETF short allows for less potential upside than a leveraged play, but in doing so you avoid paying a time premium. My preferred method is to short indexes via put options. During significant sell offs, stocks generally fall in unison, while diversified ETFs garner lower options premiums than more volatile individual stocks. Technology (QQQ), homebuilders (XHB), retail (XRT) and financial (XLF) sector ETFs as well as broader ones (SPY) offer appealing prices on the massive leverage that comes with options.