What to do about a perfect storm in the stock market
This Canadian analyst was calling for stormy markets before last week’s panic, and suggests some ETFs to buy before the next storm.
One storm blew through last week.
We’re not sure when the next one is, but we all know it’s coming.
The stock markets are entering a turbulent period, says one Canadian analyst, and investors have only themselves to blame if they’re not ready.
In fact, Mr. Keith Richards predicted “a perfect storm” in the markets as early as March in his Investor's Digest of Canada column.
In his latest column, he has a further storm warning — and this was written before last week’s Greece-inspired panic on the Streets.
There are four very good reasons to batten down the hatches, this seasoned portfolio manager tells his readers.
And there are a select group of exchange-traded funds, he adds, with which you may wish to do your battening.
When rates go up
With or without short-term shocks to the market, the risk for investors is now rising, cautions Mr. Richards.
The first red flag for investors should appear just over two weeks from now. On June I, the Bank of Canada will make its next announcement on interest rates. The overwhelming consensus is that rates are going up.
“When our central government tightens, it’s more often than not a bad thing for both bond and stock markets.”
Second on the watch list is the price/earnings (p/e) ratio. When this ratio hits 20, stocks are considered fully valued. The S&P 500’s trailing p/e ratio (the ratio based on past results, not forward estimates) was pushing 22 even after last week’s market mayhem.
Historically, adds the analyst, the ratio reaches a maximum level of 23 to 25 before “a major market correction” ensues.
Don’t be the sucker
Mr. Richards’ third warning sign can be found on the technical charts. As a rule, he says, resistance to further upward movement comes when the Dow Jones Industrial Average reaches 11,500. It opened this morning at 10,748 after another Euro-sceptical day on the Street.
In plain English, the analyst says, “resistance” simply means the point at which lots of buyers have purchased stocks in the past and want to get their money back as they see their capital recover.
“They want to sell to another sucker so they are out of the risky stock game.” Don’t be that sucker, he advises his readers.
Go away?
Finally, there is the simple fact that it is May. The math has been done over and over again and it is clear that the stock markets tend to make the greatest gains between November and May.
You don’t necessarily have to “sell in May and go away,” as the saying goes, but you should be aware that the markets almost always slow down during the spring and summer months.
With these four warning signs before us, there are specific steps to be taken. If you accept his prognosis, Mr. Richards says, you may wish to follow a strategy he has put in place for his clients.
To begin with, he has rotated out of longer bonds into shorter bonds (less than four years to maturity). So far, this strategy has worked.
He is also adding real return bonds, which are adjusted for inflation and will help preserve capital against the double whammy of rising rates and looming inflation. He does this through iShares Dex Real Return Bond (TSX-XRB). This ETF is trading today at $20.80.
Going on defense
Mr. Richards has also made some “significant changes” to his equity portfolios. He has “drastically reduced or eliminated” his commodity holdings and cut back on broad market index shares.
Oil was a strong investment in February, he adds, but after a 15 per cent rise in the price of crude, it may be time to back off. Ditto consumer discretionary stocks (basically, things you can do without if you have to).
It’s time to go on defense, the analyst states. He does this with cash, or T-bills and also with the things you can’t do without, consumer staples.
This leads him to another ETF. It is Consumer Staples Select Sector ETF (NYSE-XLP), which is trading today at $27.52. While it does trade in U.S. dollars, Mr. Richards is convinced “that the majority of the currency risk for Canadian investors on U.S. securities has ended.”
And remember, he adds, that during the Great Recession of 2008, consumer staples in general, and this ETF in particular, were among the few investments to rise.
This analyst suggests one more defensive manoeuvre for his Investor's Digest of Canada readers. When the warning signs point to a severe market correction, investors might wish to try inverse ETFs — funds that pay off when the market goes down.
He advises conservative investors to avoid the so-called leveraged funds that offer two-for-one returns. Instead try the funds that simply go up as much as the market goes down, like a teeter-totter.
He has two choices. One is Horizons BetaPro S&P/TSX 60 Inverse ETF (TSX-HIX), which would cost you $11.94 today. The other is Horizons BetaPro S&P 500 Inverse ETF (TSX-HIU), now trading at $9.29.
So far, the markets are having a sunnier day today than they had yesterday. But this analyst is not the only one telling us that more storms are surely on the way.
It’s a wise investor who prepares for trouble rather than waiting for the clouds to burst.
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