Daily Gains Letter

S&P 500 Approaching Inflection Point; How to “Insure” Your Portfolio

By for Daily Gains Letter |

Stock Market's Volatile ShiftsThe winds are changing, my friends. For most of the past year, each time the S&P 500 sold off, it was a buying opportunity. I think we are at an inflection point this year, as we all know nothing lasts forever.

I believe it all began to emerge last week with the Federal Reserve meeting. As long-time readers know, over the past couple of months, I’ve been warning that once the Federal Reserve begins to adjust monetary policy, this will have a negative impact on the S&P 500.

With the Federal Reserve continuing to reduce its asset purchase program, investors are now calculating the length of time until it’s no longer. The reason for distress in the market is that Federal Reserve Chair Janet Yellen announced a tentative six-month timeframe upon completion of the asset-purchase program that the Federal Reserve will begin increasing short-term interest rates.

Why the concern?

Taking a quick look from several angles, this transition won’t be smooth. To begin with, there’s the old saying on Wall Street: “Don’t fight the Fed.” It is obvious that the Federal Reserve is dead set on reducing monetary stimulus and raising interest rates.

Very rarely does the S&P 500 increase during a period of monetary tightening. This is not to say that the S&P 500 will drop tomorrow; the Federal Reserve is continuing monetary easing for the moment. But investors in the market should be aware that once the Federal Reserve begins changing its monetary stance, the S&P 500 will be affected.

Another concern is that economic growth in America isn’t exactly on fire. While it’s true that we aren’t in the depths of a recession, economic growth is far from optimal. Frankly, I can’t recall a time that the Federal Reserve began tightening monetary policy when economic growth was so tepid.

Then we can look to economic growth globally, which is even more worrisome. For March, China’s Purchasing Managers’ Index (PMI), tracked by Markit Economics and HSBC Holdings plc (NYSE/HSBC), was 48.1, a drop from 48.5 in February. Remember that a level below 50 signals economic contraction. (Source: “HSBC Flash China Manufacturing PMI,” Markit Economics, March 24, 2014.)

In this PMI report for China, Markit Economics remarked that the slowdown in economic growth was broad-based. The company believes that Chinese leadership will enact new policy measures to try and pump up overall economic growth.

What does this tell us? After trillions of dollars pumped into the financial system by central banks around the world, economic growth remains tepid. With this backdrop, can the S&P 500 continue setting all-time highs over the next year, even as global economic growth appears to be slowing and the Federal Reserve will shortly begin tightening monetary policy? I think it will be much more difficult for the S&P 500 going forward.

One thing I do consider quite likely is that volatility will begin increasing.

ProShares VIX Mid-Term Futures ETF Chart

Chart courtesy of www.StockCharts.com

The above chart shows the S&P 500 (black line) superimposed over the volatility exchange-traded fund (ETF) ProShares VIX Mid-Term Futures ETF (NYSEArca/VIXM). As you can see from the past, when the S&P 500 drops, the volatility index (red candlesticks) rises. This volatility index can be seen as a hedge or insurance policy against extremely fast and sharp declines in the S&P 500.

Improving your financial health is all about probabilities. When you combine all of the potential problems for the S&P 500, whether it is tepid global economic growth or shifts in the Federal Reserve’s monetary policy stance, having some insurance makes sense, considering the all-time highs that the market is currently facing.

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