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Between late November to the beginning of May this year, the S&P 500 (SPY) has risen over 20%. On the morning of May 9th before the markets opened, founder of Portfolio Café, Tim Fortier, issued a warning to all his clients to hedge accounts with a 33% short position in the NASDAQ (SQQQ). Earlier he encouraged clients to purchase a VIX exchange traded fund (VXX) as it sat just north of $17 to protect against rising volatility.

While no person can accurately forecast the market, was the right call made to investors? Let's take a closer look at the market action and see.

S&P 500 Forward Earnings

Before we look at a price chart, what does the fundamental earnings forecast tell us about the market? Below is a chart with the current year expectations of the S&P 500 earnings for the past 3 years.

(click to enlarge)

While there was a stall zone in the earnings last year (around July), the current S&P 500 EPS is still trending upwards without any substantial downward revision by analysts. Some use the forward EPS trend for the market as a major market signal. So far so good...right? Well, nobody has ever accused the analysts of leading the market with their revisions, so let's poke around a bit more.

S&P 500 Valuation

A second method to determine if the market is a good buy is to consider the difference in earnings yield of the market and the 10 year T-Note. Comparing these two numbers makes the S&P 500 look like a strong value play with a gap of 5.86%

(click to enlarge)

Yet, the counter-argument to this valuation is that it looks high based on the artificially low interest rate and the earnings may drop once interest rates are boosted.

Matthew Rubin Sees Rising Markets

A writer at the Financial Times, Matthew Rubin, sees better markets ahead as he points to strong corporate earnings. Receding volume? Matthew isn't overly concerned since volume signals are becoming less relevant with the proliferation of high-frequency trading. As well, this merely represents the 'wall of worry' building over the past three years. The idea could be that if earnings persistently trump unfounded fear and investor confidence is re-gained, volume could increase.

But what is the dark side to our current market?

Market Price Trends

Near the beginning of April the upwards price trend in the S&P 500 broke down. This prompted the first warning by Tim Fortier to hedge with the VXX ETF. The market churned and tried to rally but failed to break new highs in late April. This led to another downward move which fell past the previous low from a month earlier.

(click to enlarge)

Down Trend Accelerating?

Also worthy of note is the ADX indicator on the bottom of the chart, which is a common trend following tool. As the ADX line decreases, the trend is weakening. As the ADX rises, the trend is strengthening. A common trigger for trend-followers is enter the market when the ADX rises past the 20. The goal is to catch a trend early on. It should be taken as an ominous warning that the ADX has done just that as index prices are making new lows.

New Downward Channel?

Also take note of the newly formed downward price channel, of which we are scraping bottom. Don't be fooled into the thinking that the bottom of this channel is some strong support. Downside price action can be fast and scary with extremely sharp drop-offs when investors panic.

(click to enlarge)

Short the NASDAQ as a Hedge

The first 3 months of 2012 the NASDAQ outperformed the S&P 500 index by almost double (chart below). So why short a NASDAQ ETF as a hedge?

(click to enlarge)

Have a look at a more recent chart since mid-April (chart below). The QQQ is far more volatile and susceptible to downside moves. While the SPY dropped 1%, the QQQ fell three times that hard.

(click to enlarge)

How to Play the Market

One of the best ways I can think to play this market is to follow Tim's advice and keep the 33% position hedge in the NASDAQ or (perhaps in addition to) a volatility hedge with the VXX. Which stocks will you hold? This is personal preference but I have found that strategies targeting short-term price moves may be the most prudent.

For instance, I run a weekly scan of certain upgraded S&P 500 stocks and rebalance weekly. Over the past 3 years this strategy holds an average of 7 stocks with less than half being replaced every week. The historical gain has been an average of 0.79% versus the index gain of 0.30%.

Chart compliments of Portfolio123

(click to enlarge)

Keep in mind that this is an active strategy and you'll need to have incredibly low brokerage fees and limit orders to manage slippage in order to make this a doable system. 5 stocks making the upgraded list this week are:

Ticker

Name

MktCap

Vol10DAvg

(TER)

Teradyne, Inc.

2930.75

2.75

(CINF)

Cincinnati Financial Corporation

5859.72

0.73

(PWR)

Quanta Services Inc

4837.03

2.54

(SHW)

Sherwin-Williams Company

12674.17

1.3

(PPG)

PPG Industries, Inc.

16019.02

1.19

Am I saying that these stocks will fly high over the next week? No, but these 5 stocks are sound picks when you have a hedge in place as this type of stock typically falls less and rises more than their counterparts. Until the market firms up, I also recommend making judicious short-term plays while protecting your downside to lower risk until we see a resumption of an uptrend.

Source: Is The Market Ready To Topple?

Additional disclosure: Partners, subscribers and clients at Portfolio Cafe may have positions in any of the above mentioned funds and stocks.