Preparing for the Fall, Part II

Includes: DIA, QQQ, SPY
by: Graham Summers

In Friday’s essay I warned that stocks were headed for an ugly autumn. Looking at Friday’s action—the S&P 500 fell 3%— it’s possible the trouble is already here.

As I’ve mentioned several times on these pages, the market rally post-Bear Stearns was largely facilitated by phony economic data courtesy of the US government, the Federal Reserve pumping dollars into the system like there’s no tomorrow, and dumb money piling into stocks, thinking the worst is over.

Looking at these trends, as well as the market’s declining volume— a telltale sign of a “sucker’s rally” —I forecast that eventually this web of lies and frauds would come undone and the market would enter another fierce correction. Friday may have marked the beginning of this.

I strongly suggest you take steps to protect your portfolio now, if you haven’t already done so.

The first thing I’d do is shift any “uncertain” positions into cash. My reasoning for this is simple. If your analysis is sound, you can stomach watching your position lose 15-20% of its value and still hold strong. Heck, you might even average down and increase your position, thereby lowering your average buy price. A strong investment thesis allows for this kind of certainty even in choppy markets.

However, watching a speculative position fall only brings misery. When an investment is based on hopes and fears, there isn’t a whole lot to fall back on when it turns against you. At that point, you’re at the market’s whim and you’re in for a gut-wrenching ride. The market is meant to be taken advantage of, not to take advantage of you. Reducing your speculative positions is one way of insuring the former and protecting against the latter.

A second item to consider is opening a few short positions. I’ve discussed short-selling on these pages before in our May 14, 2008 essay. If you’re unfamiliar with the concept, please review that essay in our archives.

When it comes to finding shorts in the market today, there are plenty of options. Sector-wise, I’d consider any sector that has rallied strongly since the Bear-Stearns bailout. This means financials and homebuilders. I’d also consider sectors that will suffer from a continued downturn in consumer spending, particularly retailers and restaurants.

The easiest way to short any of these is to simply short their Exchange Traded Funds (ETFs). By doing this, you’re essentially shorting the entire sector. You may not make as much money as you would if you picked a few individual stocks that tanked, but it’s a lot easier to be right when your bet is diversified.

Finally, I suggest opening a number of hedges or investments that will do well when stocks have a rough time. Historically this has meant commodities. Personally, I would steer clear of oil or any other commodity trading at an all-time high. I’m not saying oil couldn’t go higher, but buying when something is at an all-time high usually means you’ve missed most of the boat.

However, gold is attractive, particularly in light of the inflation problems in the US and elsewhere. I’d also look into agricultural commodities such as sugar, coffee, soybeans and others. There are a number of agricultural ETFs available to invest in. Most of these should do well if the market tanks.

Bottom line: I strongly suggest shifting your portfolio to the defensive. The current market climate is extremely difficult to make money in. And there is no reason to watch your wealth be destroyed because CNBC and the perma-bulls believe the bull market has begun anew. By the time they catch on that we’re in serious trouble, the market will already be headed towards new lows.

Again, I strongly suggest shifting some of your portfolio to cash. If I’m wrong, all you’ve missed out on is a few percentage points in gains. If I’m right, you’ll sleep soundly at night, while your neighbors and co-workers toss and turn wondering how much money they’ve lost.

And there is no price for that kind of peace.