Daily Gains Letter

Getting Ready for the Stock Market’s Coming Bumpy Ride

By for Daily Gains Letter |

Four Ways to Prepare for the Bumpy Ride Ahead in StocksThe S&P 500 traded at an intraday record on Tuesday, but it’s not time to relax and take it easy, as was the situation for the past few years since the Great Recession.

It’s time for some hand-holding again. While the broader market has edged higher, I continue to see some nervousness and selling pressure in the small-cap and growth elements of the stock market. The Russell 2000 is holding above its 200-day moving average (MA), but it’s tenuous.

As has been the case in the past years, the direction of the Federal Reserve is helping to support the stock market. Since taking over for the former Fed chairman Ben Bernanke, Janet Yellen appears to be just as, if not more, dovish than her predecessor, and this pleases the stock market.

The reality is that the Fed has said it will likely not begin to increase the historically low interest rates until sometime in 2015, and even then, it will likely only be a small increase. The central bank wants stronger jobs creation and economic growth.

The disastrous first-quarter gross domestic product (GDP) contraction of 2.9% was horrible despite blaming some of the poor results on the winter. A closer look shows declines on spending across the board that negatively impacted the GDP growth. The contraction in durable goods spending in May also supports the continued fragility in the economy and stock market.

The problem is that investors have minimal options for investing compared to the stock market. While the risk is prevalent, it’s clear investors are willing to assume some of the risk, but not to the same degree as in 2013 if you look at the muted price action on the stock market so far this year.

You will also see the impact of slower GDP growth on corporate America when the second-quarter earnings season comes into play in a few weeks with Alcoa Inc. (NYSE/AA) set to launch the S&P 500 reporting season on July 8. Don’t expect a lot, as companies continue to cut expenses to try to meet Wall Street-reduced earnings estimates amid the stalled revenue growth. The stock market simply wants to see some positive guidance, but this has been absent. So far, about 85 S&P 500 companies have issued negative guidance.

In other words, get ready for a possibly bumpy ride in the stock market.

Ask Yale professor Robert Shiller whether he is clearly on edge regarding the stock market. Based on what he defines as the “cyclically adjusted price-to-earnings ratio,” or CAPE, Shiller is bearish on the stock market. He notes that the other times the CAPE has been this high were in 1929, 2000, and 2007. We know what materialized in the stock market in these three years. (Source: “‘It looks like a peak’: Robert Shiller’s CAPE is waving the caution flag,” Yahoo! Finance web site, June 25, 2014.)

I strongly recommend you take some profits off the table, especially with some of the growth stocks that have rewarded you with superlative returns.

I’d also consider hedging the downside risk via put options on the key stock market indices, such as the S&P 500 with the SPDR S&P 500 (NYSEArca/SPY) exchange-traded fund (ETF), the NASDAQ with the Powershares QQQ (NASDAQ/QQQ) ETF, or the Russell 2000 with the iShares Russell 2000 (NYSEArca/IWM) ETF. You can also hedge against a downward slide in technology via the Direxion Daily Technology Bear 3X Shares (NYSEArca/TECS).

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