Earlier this week Jerome Powell and the Federal Open Market Committee decided to leave interest rates steady until September. That move may have turned out to be an even bigger mistake that holding off on hiking rates to years ago when inflation was termed “Transitory”.
Don’t get me wrong, Jerome Powell and the Fed have an extremely difficult job in trying to execute an extremely difficult balancing act.
The Fed is charged with maintaining a dual mandate of “maximum employment and price stability”. (You can read about that here) Right now, that dual mandate is like trying to balance an elephant and a giraffe on two spinning plates.
Investors didn’t expect to see an interest rate cut on Wednesday, but they also didn’t expect to see two bearish reads on the economy tank.
For months, investors have viewed bad news as good news. Slowing jobs growth and other signs that the economy was slowing were seen as confirmation that the Fed was going to cut interest rates.
Be careful what you wish for, now the Fed may need to cut rates
On Thursday, the Institute of Supply Management (ISM) Manufacturing Index came in lower than every single economist’s expectation. That number tells us that manufacturing activity is slowing much faster.
That was followed by this morning’s news that Nonfarm payrolls grew by only 114,000 in July. That number is well below the downwardly revised 179,000 in June and the Dow Jones estimate for 185,000.
The Fed’s move to hold interest rates at their highest since just ahead of the housing Crisis of 2009 now has investors second-guessing where the economy stands. That's a terrible thing to have happened at this moment in the markets.
Here’s why…
I’m probably telling you what you may already know, but let’s put it into numbers, not words.
The Investor’s Intelligence Bull/Bear ratio is a simple measure of investor sentiment. The weekly ratio represents how bullish or bearish professional financial advisors are, that’s it, nothing more.
Historically, when the percentage of advisors that are bullish reaches 60% it’s a sign that investors have become too optimistic.
This is why that’s a problem.
Stocks are driven higher by one thing, investors buying more stocks. Again, that’s simple. The catch is that if everyone is bullish – or most of them are – it means that there is no one left to push the market higher by buying more stocks.
It’s to the contrary, which is why this is called a contrarian indicator. If everyone has already bought stocks it means that there is more potential selling pressure in the market. All it takes is a reason for people to start questioning how bullish they should be, which is your classic trigger for a correction or worse.
That sentiment was also reflected in low readings of the CBOE Volatility Index ($VIX).
The “VIX” is well known as the market’s fear gauge. Low readings indicate that investors are optimistic about the future for stocks while high readings signal panic or fear.
Today’s readings of the VIX moved higher than the high readings that we saw in April and last October. Each of those readings signaled market bottoms.
But here’s the catch, breaking above those readings indicates that the market is reacting more fearfully than previous spikes in this fear indicator. That means that we’re more likely to see stocks continue a longer, more pronounced pullback.
This is the simplest to understand…
They say that “The trend is your friend”, right? Well nobody talks about what happens when the trend isn’t your friend, and that’s something to be concerned about.
Last week, the Nasdaq 100 broke below its 50-day moving average. Today the S&P 500 and the Dow Jones Industrial Average are following suit.
This means that all three of the major indices are breaking critical trendline support. That in and of itself has negative consequences.
Focusing on one of the three, the Nasdaq 100 is the trendline to watch.
The index houses the large cap technology companies like NVIDIA (NVDA), Microsoft (MSFT), Amazon (AMZN), and Alphabet (GOOGL).
Three of those four companies just stoked the selling flames by failing to raise their earnings outlook for the next quarter. This happened while the market was in that optimistic or euphoric state that I mentioned above.
One of my “Ten Commandments of Trading or Investing” is that the market’s are driven higher by speculation, not necessarily fundamentals. The last two weeks have taken investors’ reason to speculate on higher prices away as technology companies at the heart of the market’s strength haven’t raised the market’s expectations for their forward-looking growth.
This clashes with the overly optimistic sentiment that has driven these stocks well above their valuation to create a “sell the news” market, breaking the market’s bullish trends.
Investors looking for the next support level for the Nasdaq 100 will find it at $230, another 5% lower than its current price.
The Fed’s hold on interest rates, weaker than expected earnings outlook and technical breakdowns are all happening at the worst time.
August and September are two of the worst months of the year for stocks.
The poor performance is a combination of light volume trading and volatility as the market heads into what is perceived as the worst month of the year, October. Sidenote, October is actually a good month for stocks. It’s the “Comeback Kid” that often results in the kickoff of a great fourth quarter for the markets.
But that’s two months away.
For now, you should expect to see selling pressure remain constant through the months of August and September, driving prices another 5-10 percent lower, and that’s the optimistic outlook.
At this point, two things can pull the market out of its summer slump.
Regardless of whether these two happen, investors are uncertain… and uncertainty is never good for stocks.
With that in mind, the way to position for a rough two months is to consider two defensive moves.
Every investor out there is well-served to review their portfolio holdings on a regular basis. Now is the time!
You’ll find that the nimble traders are setting stop-limit sell orders to ensure that losses don’t get out of control. This is an easy way to take the emotions out of investing that pays off over the long run.
Here are the basics of Stop-loss and stop-limit orders.
One suggestion, if you sell a stock that you want in your portfolio for the long run consider setting a target price at which you’ll buy it back. This will help to make sure that you’re defensive move to avoid losses pays off by buying the stock back at a lower price.
Consider adding an inverse Exchange Traded Fund (ETF) or a defensive put to your portfolio.
Inverse ETFs are an investment that increase in value as the market goes down.
Read more about inverse ETFs by clicking here.
For example, the Ultrashort QQQ ETF (QID) goes up roughly 2% for every 1% decline in the Nasdaq 100.
Adding the QID to a portfolio will help to offset losses that you would see from holding large cap technology stocks in your portfolio.
As it stands right now, the QID shares are trading 25% over the last three weeks as the Nasdaq 100 has fallen about 11% over the same time period.
The ETF is an easy addition to a portfolio since you buy it just as you would any stock.
Pro tip: Don’t get too greedy with a hedge like the QID. Set a target price for closing the positions. There’s nothing worse than holding a portfolio hedge too long to have it start losing money.
As of now, my charts suggest that a potential closeout for a QID position would be between $47.50 and $50. That’s 10-12 percent higher than where it sits as of this writing.
Put options are a great way to protect a portfolio in these conditions, this is how the pros do it.
Put option values increase as the underlying stock or index goes down.
This is a more advanced approach to hedging your portfolio, but its also the most efficient. Think of this approach like you would a term insurance policy. You pay a premium for a put option for a certain time period’s worth of protection. At the end of that time, the protection expires.
Read more about this approach here: https://www.investopedia.com/articles/optioninvestor/07/affordable-hedging.asp
I’ll cover the use of all three of these hedging approaches next week with a little more detail and examples of each.
Until then, stay safe in the markets.
