Market Downturn Approaching; Go Long the Ultra Shorts?

by: David White

It is time to worry about a market downturn. There has been almost consistently bad economic news reported in the U.S. in the last week. Following is a brief list (mostly from Yahoo Finance‘s Economic Calendar) of troubling news:

  1. The Trade Balance for March was worse than expected at -$48.20B vs. an expected -$47.00B (the previous month’s was -$45.40B). Pundits are speculating that this will result in a lowering of the Q1 GDP estimate, which is due out May 26.
  2. The Mississippi Flood is the worst in a century-- this alone will depress the Q2 GDP. Shipping down the Mississippi has slowed (or sometimes stopped). Huge numbers of casinos have closed. Farms and towns have been flooded.
  3. The PPI missed at 0.80% vs. an expected 0.60%. The Core PPI missed at 0.30% vs. an expected 0.20%. Also, the continued large spread between the CPI and PPI numbers means that many companies are eating a good part of the quickly increasing input costs. This should hurt margins going forward.
  4. Retail Sales (MoM) missed at +0.50% vs. an expected +0.60%.
  5. Some good news Friday had the Michigan Consumer Sentiment Index beat at 72.40 vs. an expected 70.00.
  6. The NY Empire State Manufacturing Index missed at 11.90 vs. an expected 19.60.
  7. The TIC Net Long-Term Transactions missed at $24.00B vs. an expected $57.70B.
  8. The NAHB Housing Market Index missed at 16 vs. an expected 17.
  9. Housing Starts missed at 0.52M vs. an expected 0.57M.
  10. Building Permits missed at 0.55M vs. an expected 0.59M.
  11. The Capacity Utilization Rate missed at 76.90% vs. an expected 77.70%.
  12. Industrial Production (MoM) missed at 0.00% vs. an expected +0.50%.
  13. Several blue chip companies such as Cisco (NASDAQ:CSCO) and Hewlett Packard (NYSE:HPQ) gave very weak guidance going forward, as though they are expecting a soft spot in the economy.
  14. The Fed Minutes indicated that they had considered ending QE2 before its stated end, but decided to proceed since it was so close to the end. The Fed also talked about how to withdraw stimulus. There seemed to be no serious consideration of a QE3. There are only a few crumbs left of the manna of the market hypers (QE2).
  15. Congress has allowed the debt ceiling to be exceeded. Geithner is now borrowing from Peter to pay Paul, and August 2nd is the day that he says this must stop. The Republicans are using the threat of a default as leverage to get concessions on many of the spending cuts they want. They will get spending cuts, which means tightening! Tightening tends to push the equities markets down. Hopefully the U.S. will not default.
  16. The USD has been rallying. The above mentioned tightening should help the USD rally. If the USD continues to strengthen, that could cause an unwind of the USD carry trade. This would translate into selling of equities and commodities. A stronger USD would mean commodity prices would likely fall.
  17. The Initial Jobless Claims were 409K vs. an expected 420K, but the previous week‘s number was revised upward to 438K. While it was pleasant to see a beat for a change, the overall trend is still bad. The 409K means the total increase in Initial Jobless Claims in the four weeks since the end of the last Nonfarm Payrolls surveys’ data period has been 159K. Additionally, the 68K jobs from the one-time McDonald’s (NYSE:MCD) hiring spree that padded the last Nonfarm Payrolls report will not be there to prop up the next report on the first Friday of June. This means that the next report will be shy a total of 227K jobs. The Nonfarm Payrolls number is likely to be a big disappointment.
  18. Existing Home Sales dipped in April to 5.05M vs. an expected 5.22M and a previous 5.10M.
  19. The Philadelphia Fed Manufacturing Index missed terribly at 3.90 vs. an expected 20.00 and a previous 18.50. This is truly ominous when combined with the terrible NY Empire State Manufacturing Index miss (see above).
  20. The Leading Indicators for April missed at -0.3% vs. an expected 0.0%.

If the U.S. news wasn’t bad enough, the EU credit crisis is alive and well. The scuttlebutt on Greece is that it is no longer a matter of “if” Greece will default (give a haircut), but “when“. Ireland may have some of its banks give haircuts to debt holders. Portugal’s bailout has been okayed in principal, although Portugal still needs to elect a government to accept it. That government also needs to approve the necessary austerity measures to qualify for it. The previous government dissolved because it wouldn’t approve such measures just a couple of months ago. Portugal is predicted to go back into recession for 2011 and 2012 based on the harshness of the necessary austerity package.

In Japan, the economy shrank quarter over quarter in Jan-Mar by -0.90% vs. an expected -0.50%. Year over year Japan's GDP declined more than expected by -3.7%. This is the second consecutive quarter of decline. Japan is technically back in a recession. Its GDP Price Index (YoY) was down -1.90% (deflation). Its Industrial Production (MoM) was down a horrendous -15.50% vs. an expected -15.10%. Its Household Confidence missed at 33.40 vs. an expected 37.30. Public debt has reached 200% of GDP. Things are so bad there that ECRI has forecast a global summer slowdown.

In sum, there are sufficient reasons to expect a downturn in the U.S. equities markets. The manna of the “hypers”-- QE2-- has been reduced to a few sparse crumbs. The signs point downward. Of course, the market has proven better men than me wrong...

After reading all of the above, what can you do? The simplest idea is simply to move a substantial amount of your equities investments into cash for the summer. Logic says the fall will be a better time for investments, presuming the EU credit crisis does not cause another global recession / slowdown.

An alternative for those who wish to stay invested might be to sell call options on most of the stocks owned. The premium for the options would give you some profit if stocks go up. The premium would give you some protection if your stocks go down.

For those of you who don't want to bother with the complications of shorting (but do want the effect), you can by the triple short ETFs: SQQQ, SDOW, SPXU (S&P500), and SRTY (Russell 2000).

For those who prefer simple shorting, you might consider shorting (for most of the summer) one or more of the major indices via vehicles such as the SPY (SPDR S&P500), the QQQ (Power Shares QQQ), the DIA (SPDR DJIA), and the IWM (iShares Russell 2000). Before you short any of the above, you should note the recent ex-Dividend dates are: SPY (3-18-2011), IWM (3-24-24), DIA (4-15-2011), and QQQ (3-18-2011). The next ex-Dividend dates will be approximately 3 months from each of the respective dates above. If you are short at the time of the ex-Dividend, you will be responsible for paying the dividend. You may wish to cover your short position for the day or week of the ex-Dividend.

If you want to manage the risk of the above described short positions, you can sell covered put options on your short position(s). You can use the premiums from those puts to give you protection against a move upward. For some ETFs such as the SPY, there are weekly put options available. If you sell these each week, you will collect a lot of time premium.

For those still more aggressive investors, you might consider buying put spreads on one or more of the above mentioned vehicles. To be safe, you might consider expiration dates in Aug., Sept., and Oct. You almost have to use spreads to manage the risk. They cut down on the costs, making such a trade profitable with less actual movement down.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in SPY, IWM over the next 72 hours.