“Phase 3” Right Around the Corner for Stocks

For those of you that read my latest letter to clients (which I’m sure everyone did…but if you haven’t had a chance yet, you can find it here), the S&P 500 is about to enter what I consider “Phase 3”.  This means it’s time to aggressively hedge/reduce stock risk.

I spent a good bit of time over this past weekend assessing the markets and decided it was time to add some protection to our “growth” allocations via put options.  The Russell 2000 (small caps) and the Dow have both entered Phase 3, and the S&P 500 will be joining unless we can rally about 5% over the next week, which looks unlikely.  Fortunately we were given a very nice gift with the markets rising over 2% on Tuesday which allowed me to cut back on some individual stocks as well as purchase our put options at cheaper prices.  I’m targeting a full hedge over the next year against a 20% drop.

What exactly does Phase 3 mean?  It means that the probability of stocks posting a negative return over the next year is fairly high.  Historically, Phase 3 has played out in different ways given the type of economic and market environment we were in.  There were times that the stock market bounced back rather quickly and actually posted positive returns over the next year, but there were also times that we saw pretty damaging drops (i.e. 2008).  Obviously I can’t predict the future but at this time I feel it is absolutely appropriate to own some protection.

Things really seemed to change after the announcement that China was going to allow the Yuan to depreciate.  As previously discussed, this is going to apply further deflationary forces on the global economy.  I also believe it will trigger the next bout of competitive currency devaluations.  The US dollar bull market continues… and if the Fed raises interest rates next week, look out!  Accordingly, we’ve seen the most cyclically sensitive companies roll over and get hit the hardest.  Despite making a few purchases in these industries over the summer, I’ve changed my view and have really cut back our exposure.  When the facts change, sometimes you have to change your opinion…

The “feel” of the stock market has changed over the past 2 weeks.  Volatility has remained much higher than the past few years with the Volatility Index (VIX) hanging around north of 25.  For comparison, the VIX could barely get over 20 the past few years.  We’ve also failed to sustain a bounce despite very oversold conditions, running into plenty of distribution.  The levels that used to be support have now turned into resistance.  Both are warning signs that we’ll likely be seeing lower prices in the very near future.

Volatility Index (VIX) – 3 years (weekly chart)

S&P 500 – 1 year (daily chart)

This post might seem pessimistic but I actually view this as good news.  Volatility is an opportunity if you’re ready for it.

-Nick