Thursday, January 7, 2016

What's Working in this Market Correction

The New Year starts with a bang, with hundred points swings in the Dow Jones Industrial Average each day this week. Unfortunately, the swings have all been to the downside, with the S&P falling nearly 5.0% this week. In this environment, investors may be tempted to throw up their hands and sell everything, or watch from the sidelines like a deer in the headlights as portfolio values head ever lower. Let's look at what's actually working.

First, while some portion of the selloff was likely initiated by the Fed's modest rate hike in December, the 0.25% increase has all been directed at the short end of the yield curve. Bonds, especially long-dated bonds have performed quite well, with the yield on the 30-year UST falling below 3% (2.93% as of this writing) from a level of 3.04% just last week. Eleven basis points of declining yield has the price of the US Treasury 2x ETF (UBT) rising from $73 to $76 over the same period. That's a 4% gain for the week, while everything else seems to be swimming furiously in a sea of red.

This leads us to our first trade for the New Year, bonds, and specifically UBT as an ETF play available to retail investors. UBT is levered 2x which means that a rise in long term interest rates would also cause this instrument to fall disproportionately in value. But if your view is that the economy may be hitting a rough patch, where stocks are susceptible, then bonds may provide a safe port in the storm. This is especially true if you believe economic growth and inflation, the principal enemies of bonds, will continue to be subdued. It's also worth noting that UBT traded as high as 97 back in February 2015, when the long bond traded at 2.25%. Not to say this is where things are headed, but with the softness we're seeing in global markets, difficult to rule it out either.

Oil continues its rapid decline, now bordering on a free-fall. The inverse leveraged ETF, SCO, has done especially well over this period, rising from $80 in the beginning of November to its present level of $160. How much lower oil can go is anyone's guess, but WTI is now roughly where it was during the 2009 recession (along with other commodity prices). Hard to believe it falls much further, yet SCO may still form a reasonable hedge against long positions, certainly in energy and perhaps, also, industrial stocks.

SKF, the inverse leveraged ETF on financial services stocks, also has our attention. This instrument can not only provide a hedge against other long equity positions, but highlight the risks specific to the financial services sector. Some concern with financial services profits may be warranted following the poor performance of markets in the latter part of 2015 and the disastrous 4th quarter results posted by Jefferies on December 15. Customarily a harbinger of things to come at the larger Wall Street names, our concern can only be amplified by the exposures of these firms to deteriorating credits in the oil patch.

On the long side, defensive sectors like healthcare and utilities may prove a good place to hide, collecting dividends and waiting for markets to sort themselves out. As to cash, which investment advisors tend to dismiss, it's beating stocks by 4.89% this year.