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If this market is vulnerable, what should I do?

I’ve been asked that question repeatedly since I first called this market vulnerable back in my October 11 post “Suddenly U.S. stocks seem vulnerable.”

To answer that–the what should I do part–let’s first take a deeper look at the two key words in my question, the “if” and the “vulnerable.”

There are good reasons to believe that the market might be vulnerable right now–but they don’t add up to a guarantee of the “if” in my question. (When do they ever? This is investing not a relief appearance by the Indians’ Andrew Miller.)

Financial markets are almost certainly looking at an interest rate increase from the Federal Reserve on December 14. The dollar is likely to resume its rally–at the expense of the euro and emerging market currencies (and earnings at U.S.-based multinationals.) OPEC is supposed to put production caps in place at its November 30 meeting but that is, at this point, more wish than certainty, as far as oil prices are concerned. China’s banking system is wallowing in bad debt and the worse than expected export numbers suggest a threat going forward to the 6.7% growth rate recorded in the second quarter. The Saudi central bank is pumping cash into the country’s banking system in an effort to head off a liquidity crisis brought on by the drop in oil prices but so far the effort hasn’t produced much relief. In the United States earnings for the third quarter are expected to be either negative or just slightly positive. That’s not exactly the stuff that rallies from near-record highs are built upon. Emerging financial markets from Mexico to Brazil to Thailand are facing political crisis. We have nasty and ongoing wars in Syria and Yemen and Afghanistan. (Am I missing some?) The likelihood of a hard Brexit is leading European leaders to warn of economic slowdown. (Just what Ireland needs, I’m sure.) And then, of course, there’s the U.S. election, which has turned so dark that Canada has launched a social media campaign to cheer us up.

I can, however, put together a list–albeit shorter–of potential events that could break in the market’s direction. Third quarter earnings could show slight year over year growth, which would allow the market to continue to believe that fourth quarter growth will be substantially positive. OPEC could, now don’t laugh, actually deliver at its November 30 meeting an agreement promising to reduce production. (Which is not, of course, the same as delivering actual production cuts.) The dollar could hold at current levels (instead of climbing) on a conviction that the Federal Reserve policy will be one interest  increase in December and then none in the first half of 2017. That would allow emerging markets and emerging market currencies to muddle through. The rise in cash levels in fund portfolios could, indeed, turn out to be a contrarian “buy” signal. Cash balances at fund portfolios climbed to 5.8% in October, up from 5.5% in September. That’s the highest cash position since the immediate aftermath of the Brexit victory. All that cash is, in the contrarian view, cash that could go to work buying assets. The U.S. election could end with a Clinton victory and without any of the “The election is rigged” violence that seems so possible right now. Hard Brexit rhetoric by European leaders could moderate. The videos on Canadian website “Tell America It’s Great” could go viral and everyone in the United States could start feeling better.

If you objectively add up the things that could go wrong and the things that could go right, the “wrongs'” have it. I’d put the odds that this market is “vulnerable” at something like 70/30. But do your own math on the “if” part of my question.

Which leads very naturally into a discussion of what “vulnerable” means at the moment and in this market.

Looking back at my “if” discussion I don’t see a market meltdown. The likely course of interest rates–one increase in December and then, at the most two, in 2017–remains supportive of stocks even if slowly increasing interest rates aren’t the stuff new highs are made of. Economic growth is below what used to be the trend, but the U.S. economy is still growing and a turn in the business cycle toward recession doesn’t look like a 2017 event. A strengthening dollar, even if the gains in strength are relatively modest, sends global cash into dollar denominated assets, which is good for U.S. stocks and bonds. (And raises the possibility that bond yields won’t rise as much as you might expect from the Fed’s moves.) Central banks are struggling to find policy responses to slow growth and tight liquidity but they certainly aren’t asleep at the switch. I don’t see the kind of contagion that leads to a replay of the Global Financial Crisis. I don’t see another October crash.

What looks most likely to me is a move downward of 5% to 8% in U.S. stocks. Which would be a continuation of the modest retreat of the last two weeks of so. And a bigger move downward in some other non-U.S.asset classes as the markets replay the flight to safety response that has been the default reaction to rising worry every time the rally pauses. This is why I’ve been tracking the signs of a move toward a risk off market so frequently in the last couple of weeks.

A risk off market reaction would extend the weakness in what are perceived as risky asset classes. From October 10 to October 17, for example, the iShares MSCI Emerging Markets ETF retreated 3.3%. (Emerging markets rallied today, climbing 1.76% as the mild inflation numbers from the United States led to weakness in the U.S. dollar. The Bloomberg Dollar Spot Index fell 0.2% today, October 18.)

It would mean further weakness is some domestic sectors that are also seen as risky, such as biotechnology. In the same October 10 to October 17 period when the iShares Emerging Markets ETF fell 3.3%, the iShares NASDAQ Biotechnology ETF (IBB) dropped 7.8%. And like the Emerging Markets ETF, the Biotechnology ETF was up today, October 18, by 1.47%.

It tells me something about this market that assets that are normally all seen as risk off are moving together. (The Biotechnology ETF carries the added burden of a Wall Street belief that a Clinton administration would be tougher on drug pricing and reimbursement than a Trump administration would be.”

“Normally” risk off is a key concept. If you start to see selling in the high price-to-earnings stocks that have led the last leg of the rally–Amazon (AMZN), Facebook (FB), and Netflix (NFLX), for example–then I think it’s time to consider the possibility that we’re looking at something more than a 5% to 8% drop and a move to a risk off market. More on this later.

That’s my take on “if” and “vulnerable.” Now let’s proceed to three moves for this specific vulnerable market.

Move 1: If what we’re looking at is a risk off market and a 5% to 8% drop in U.S. stocks with a bigger loss in specific risk-off assets, then there’s no reason to sell everything including the kitchen sink or to completely disrupt your portfolio. Trimming either the size or number of positions in risk-off assets such as biotech or emerging markets seems a reasonable step. At the least make sure that you have enough conviction about these assets so that you won’t sell them at the bottom. (In other words sell now or hold through the cycle.) An alternative to disrupting positions in these areas (and setting yourself up to pay taxes if you’d be taking profits) is to use a short ETF or to sell an ETF or individual stocks short. For example, I added the ProShares Short Emerging Markets ETF (EUM) to my Jubak Picks portfolio on February 112, 2016. That pick hasn’t paid off for most of the period–I’ve been way, way too early (or completely wrong, if you prefer)–and the position is down 25.46% to the close on October 18. But in the last few days the short ETF has done exactly what it was supposed to do for the longer period. From October 10 to October 17 it gained 3.2% as the long iShares MSCI Emerging Markets ETF (EEM) fell 3.3%.  You’ll note, while you’re thinking of downside protection, that the short Emerging Markets ETF is down about twice as much as the short S&P ETF, ProShares Short S&P 500 (SH) that I added to Jubak Picks at about the same time, January 19, 2016. The S&P short ETF is down 14.72% to the October 18 close. Look to options on the VIX, the CBOE S&P Volatility Index, too, if you’re looking for some portfolio protection. The VIX has been steadily creeping upwards over the last few weeks as traders have started to think about buying portfolio protection. The VIX closed at 15.28 on October 18 and it has been as high as 16.69 recently. It was at just 13.33 on October 10 and 12.02 on September 22. With the VIX worry feeds on worry so call options on this index are worth considering if you see market turbulence ahead. (The prospect of an increase in interest rates takes some traditional safe haven hedges, such as gold, off the table until learn all that we can learn at the Fed’s December 14 meeting.)

Move 2: Think of accelerating your normal end of the year tax loss selling–I think other investors and traders will in 2016. Come November and December every year, traders and investors sell stocks that have lost money during the year to reap tax losses that they can use to offset any realized gains in the year. If this market is going to end the year on a down note–or if investors and traders just expect a down market through the end of the year–then tax selling will take place earlier. Especially vulnerable will be stocks with big recent gains but that still show big losses for longer holding periods. Let’s take an extreme example: Petrobras (PBR). If you had bought shares of this Brazilian oil giant on August 25, 2014 at $19.57, you would still be underwater at the October 18 closing price of $11.77. But you would also be up huge in 2016. The stock traded at just $2.93 on January 26, 2016. You tell me how much of the 2016 gain you’d be willing to risk by holding on through end of the year volatility–especially if (win-win) you could reap a big tax loss to use against other gains in your portfolio by selling earlier than usual. Even if you don’t need to reap tax losses yourself this year or don’t use that strategy, you still need to consider the effect of other investors and traders’ tax selling on your portfolio. Tax loss selling will just add more impetus to normal profit taking if the market starts to look rocky over the next few months.

Move 3: Avoid–or at least calculate the benefits of avoiding–sector exposed to events that will introduce more volatility into the financial markets. I’d include the November 30 meeting of OPEC in this category. If the oil producers cartel doesn’t announce a believable deal to cut production, then oil prices stand a good chance of re-tracing their rally from $40 to today’s $50 a barrel. A list of other U.S. surprises would include a Trump victory on November 8, a statement from the Federal Reserve at its December 14 meeting that indicated a more aggressive approach to raising interest rates in 2017, and disappointing earnings in the fourth quarter that keep the string of negative year-over-year comparisons going when Wall Street is expecting a break into solid growth. Overseas surprises could include a drop off in growth in China rather than the currently expected stabilization and a deeper downturn than expected in European economies on Brexit fears. (At some point the drop in the pound and the euro become issues for global markets.)

I’m fully aware that all this is predicated on a projection of 70/30 for the market’s vulnerability to a downturn. The odds could be less tilted toward a market downturn than that if,  for example, third quarter earnings growth turns out to be significantly positive. And they could be worse than that if, for example, emerging market politics in Brazil or Mexico or Thailand produce a crisis, or if, for another example, the central banks of China, Saudi Arabia or the EuroZone lose control of liquidity in the financial system.

Then I’d look for, initially, an accelerated move toward risk off that expanded to include the high-PE winners from the last leg of the rally that I mentioned above. As long as investors and traders continue to hold Amazon, Facebook, Netflix and the like despite their high multiples because they believe in future growth, the vulnerably of this market is limited. If fear rises to sweep up those stocks, then we’re all playing a very different game than I’ve outlined above.