Investor Who Predicted The Stock Market Correction Offers An Update

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Includes: BAC, DIA, FB, GLD, GPRO, IWM, NUGT, OIL, QQQ, SPY, UUP, VTI, VXX
by: Markos Kaminis
Summary

Before I left for vacation 13 days ago, I warned investors of imminent market correction and suggested raising cash, avoiding stock purchases & buying volatility protection.

While I went long the market at the first trough last week and profited from bets then placed on the dollar and on stocks, I'm now preparing for another decline.

This correction and eventual recovery will be U-shaped (not V-shaped), as it is due to the market environment on Fed concerns and capital flow factors, not specific catalysts.

The volatility instruments I used (VXX calls) paid off extremely well for me but are now expensive due to broad market interest in them currently.

I'm now using new instruments to guard wealth and actually profit from the environment.

In the last few reports authored before I left for my vacation roughly two weeks ago, I presciently advised investors to: avoid new stock purchases even on dips in the market; move heavily to cash; and to hedge risk with a volatility instrument. I fended off some criticism in the article comment section to the last of those suggestions, but as a result of my own bet on risk, I turned an important percentage gain last week as most investors saw portfolio values decline sharply. I hope my followers also benefited from my advice. With consideration for my near 6,000 followers, I thought an update would be appropriate at this critical juncture to advise investors of how I'm thinking about things now and what I'm doing and preparing to do next.

When you make a statement like I have in the title to this article it's important to provide some supporting evidence. Here are my recent reports that preceded and forewarned of the market sell-off:

  1. August 18: Minefield of Risk (Recommended preparation for imminent market correction)
  2. August 13: Investors Dilemma - Do Not Blindly Buy the Dips Any Longer (As market rallied, suggested investors avoid purchase due to imminent correction)
  3. August 12: One Security to Save us All (Recommended purchase of VXX volatility investment instrument as a hedge against market correction)
  4. August 10: The Herd is in a Hurry to Get Butchered (Again advised investors not buy a rally and to expect volatility in the weeks ahead)
  5. August 9: Warning on Stocks - Keep Your Powder Dry (Warned of risk and suggested investors go to higher levels of cash)

It's important to note that I shifted my perspective early last week to advantage from the lower price levels of securities. Critically, I went long the dollar since the trough marked last week and have seen good gains there. Currently, I also have new positions in place against the risk of another market downturn, which I believe is again imminent. Though, at this point, I'm using different securities to advantage from it, as price premiums have risen in volatility instruments.

My forecast for market correction was realized over the last couple weeks. Stocks benefited last week, though, from the supportive statements of New York Fed President William Dudley on Wednesday, the strong upward revision to GDP reported Thursday and the calculated and diplomatic statement of Fed Vice Chair Fisher in his Friday interview on CNBC. These positive factors supported and confirmed my own shift to a risk on stance. But we are not through with volatility yet friends. In fact, if not for Fisher's interview Friday, I believe stocks would have sold off as investors would have avoided carrying risk into the weekend considering the Vice Chair to the Federal Reserve addressed the Jackson Hole Symposium Saturday.

Risk Remains

The factors behind the market stir remain in place into the September Fed meeting, and now tangible broad-based investor fear joins the slew of potential catalysts for further crisis. This is evidenced by the price premium surge in stock options around market ETFs and volatility instruments. Still, the days and weeks ahead will present both upside and downside profit opportunity to capitalize on or to navigate around depending on your risk preference, and I intend to help you do that.

5-Day Chart of SPY at Seeking Alpha

That's what a correction looks like up close. Doesn't look so scary does it? It's much more dramatic from ten thousand feet or as illustrated by a longer term chart. However, the 5-day chart of the SPDR S&P 500 (NYSE: SPY) here depicts the misery many of you went through. The SPY was down 11.1% from its close of $210.56 on Monday August 17 through its close on Tuesday August 25 at $187.23. It's been quite fast and dramatic, as well as consistent with how market corrections go.

Since stocks turned lower, I've heard and read about every possible reason why they did so. Followers of mine are well aware of the real reasons for it all, and I've grown tired of presenting them, but for the sake of the new reader and as a reminder to the loyal few, I'll do it one more time.

"This market is like a powder keg now sitting too close to the fire, and each news catalyst is simply an ember."

First of all, do not focus too much on the catalysts that media and market mavens alike casually call to blame. Sure China matters, and yes the snap Greek election announcement was troubling news, as are cascading energy prices. However, the truth is that the problem is more about the market environment today brought about by the Federal Reserve's plans, and it's also being fuelled by the seasonal shifts of capital flows more than any specific catalyst. This market is like a powder keg now sitting too close to the fire, and each news catalyst is simply an ember to set stocks ablaze.

I indicated after the last Employment Situation Report (for July) that the environment for stocks would be treacherous through August, September and possibly October. I now believe the brunt of the damage is more likely to be fully felt by the close of the September Fed meeting or shortly thereafter. The last jobs report and Fed meeting minutes release were relevant enough to investors to raise higher the specter of concern for a September rate action.

It's natural for investors to fret such a shift in monetary policy, given the relevance of higher interest rates to the cost of capital to corporations. If the cost of capital increases, the threshold for economic value creation is raised, and corporations must produce greater returns on investment simply to maintain the same level of value creation. Economic value creation is in turn critical to market value creation, and so equity investors are right to worry about the pending action. Their worries have been allayed now some by the upward revision to GDP, which offers justification for higher interest rates.

The market can accept higher rates if the economic situation justifies it. This will likely be what gets us through monetary tightening, though I do not expect it to be given its due credence until sometime in November or December. Until then, the cross currents in economic data due to energy sector stumbling blocks in America create concern. After then, though, capital flow factors weighing against stocks also go away (more on this coming). Before the GDP data, worries about a slowing China and its impact on energy demand and the global marketplace had enough investors worried about the possibility of a mistimed Fed rate lift-off to stir volatility. There is not a high level of confidence in the Fed's ability to forecast economic activity, and so investors tend to micromanage the wall of worry. And now even, it is taking the consoling words of voting FOMC members to stave off a second leg lower.

There's also the issue of capital flows. This is the time of year for many institutional fund managers to close their books for their fiscal year. With an eye toward performance, which plays a critical role in the acquisition of new investment capital (how they survive), portfolio managers can get quite defensive at this juncture. It lends to seasonal volatility. When you throw that in with an inflection point in Fed monetary policy you get the perfect storm for stocks.

Thus, the catalysts that are always with us tend to get a greater reaction from markets. A minor spat between North and South Korea might not have equity investors fretting before a Friday close otherwise. Neither would a Saudi Arabia troop movement rumor about Yemen trouble energy markets as much as they did Friday - the iPath S&P GSCI Crude Oil ETN (NYSE: OIL) was already off its lows on an inventory draw and strong GDP revision, but some traders were indicating the Saudi troop issue was a factor Friday nonetheless. The snap Greek election announcement stirred concern because some investors not in the know might have feared the possibility of a non-compliant new Greek leader unraveling all the good work accomplished between the EU, IMF and Greece this year. But none of the issues, not even China economic slowing, would matter as much as they do now given the Fed inflection point and the capital flow factor.

"...that is how alpha is best sought and actually discovered."

I owned call options on the iPath S&P 500 VIX ST Futures (NYSE: VXX) volatility instrument ahead of the correction I saw coming, and I advised investors to do the same in my report, One Security to Save us All, linked to above. I fielded a good amount of criticism for that contrarian view, but that is how alpha is best sought and actually discovered. It takes a lot of conviction to make that sort of a bet given the VXX tends to lose money due to the costs of its maintenance and while betting against a typically rising stock market. Today, similar securities like I used to my benefit are significantly costlier to purchase, and so the significant percentage gains I booked are harder to come by now via the same instruments.

Stocks are Indicating a Sharp Drop Today and Gold is Surging

Sector Security

Tuesday Open

SPDR S&P 500

-2.0%

SPDR Dow Jones (NYSE: DIA)

-2.0%

PowerShares QQQ (NASDAQ: QQQ)

-2.0%

iShares Russell 2000 (NYSE: IWM)

-1.5%

Vanguard Total Stock Market (NYSE: VTI)

-2.0%

SPDR Gold Trust (NYSE: GLD)

+0.7%

iPath S&P 500 VIX ST Futures ETN

+9.4%

What I'm Doing Now

Until last Thursday afternoon, I was long the SPDR S&P 500 , but no longer hold that position due to risk I see near-term. I've been long the dollar via the PowerShares DB US Dollar Bullish (NYSE: UUP), but I've recently added a hedge against my bet using UUP puts, given the volatility present today and near-term risk against my long. This market correction and eventually recovery will not be V-shaped, but rather U-shaped, because of the environment that is behind its cause. Investors should have significant cash ready to buy favored stocks at discount when further correction strikes. Three of my favorites discussed often via my column here at Seeking Alpha are GoPro (NASDAQ: GPRO), Facebook (NASDAQ: FB) and Bank of America (NYSE: BAC), each of which have their own risk spectrum. I'll be writing about them and more in the near-term.

This week is covered by the dark shadow of Friday's scheduled Employment Situation Report. I see no way the data could be seen as good, and recommend investors prepare for a second market decline that may already be in progress. I expect it would lend to aggressive selling Friday and Monday, if fear does not drive it ahead of the report. If the jobs data is in line with economists' expectations or better than them, investors will again anticipate a Fed rate hike and sell stocks. If the data is short of expectations, investors will sell stocks in fear of China economic contagion. I've added a long position in the Direxion Daily Gold Miners Bull 3X ETF (NYSE: NUGT), though I suggest investors instead use the SPDR Gold Trust for a more reliable hedge. I also have my hedge against my dollar long bet for protection against a market correction that could infect the dollar if it is spurred by weak economic data. And I'm seeking to take a short position on the iPath S&P GSCI Crude Oil TR ETN today, though not to be held long-term. Long-term equity investors willing to bear potential significant near-term downside should be rewarded for patience again toward the close of this year and start of 2016. For my market recommendations, please see my profile at Seeking Alpha to follow the column.

Disclosure: I am/we are long UUP, NUGT, GPRO, BAC. 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.

Additional disclosure: I'm also short OIL, and have minor hedges (short positions) against my long positions in UUP & NUGT due to expectation for volatility.