It is safe to say that all eyes are on Cyprus this morning as the proposed tax on savings accounts (10% on accounts over 100K euros and 6.75% on accounts below 100K) has brought the European debt crisis back into focus. As usual, the key here is the situation with the banks. First, the banks in Cyprus. Second, the banks in Greece and then the Eurozone. And finally, the banks around the globe. Who has lent what to whom? Which banks have exposure to big losses? And won't a tax on bank deposits just mean that savers will take their money and run? And then if other countries decide to adopt this type of tax in order to get help from the Eurozone, aren't bank runs a serious possibility? In short, this is what today will be all about.
But since the banks are closed in Cyprus today (and may stay closed for a while) and the bottom line is the proposal to basically grab money from the citizens of Cyprus still needs to be approved by the country's Parliament, the severity of the current problem remains unknown. (Note that new proposals such as Russia coming to the rescue in exchange for oil/natural gas exploration rights are coming fast and furious and the government in Cyprus is already backing off of the “levy” proposal to some degree.) So, while we will once again be focused on the headlines, comments, and rumors out of Europe, I think it is okay to return our attention to the bigger picture of the markets this morning.
Back To The Big Picture: How To Play the Coming Correction
Although the DJIA finished lower on Friday for the first time in eleven sessions (and was red for only the second time in the last 14 days), there was some good news. First, while everybody on the planet knows that this rally is a bit extended and vulnerable, the bears didn't really get much of anything going on Friday (and it remains to be seen how much damage the Cyprus situation will actually cause). And second, as I detailed on Thursday, a 10-day winning streak on the Dow is (a) rare (17 prior occurrences since 1900) and (b) a relatively good harbinger for the bulls.
To review briefly, if the DJIA winds up with a gain over the next two weeks, history shows that the returns for 10-day periods after a 10-day winning streak are more than six times the average return for all 10-day periods. And if the DJIA can finish higher over the next month, the average return is five times higher than normal. Then the returns for the next eight weeks (assuming the Dow is up for the period) have averaged +5.71%, or more than 5.4 times the average 8-week return. In short, THIS is what market momentum is all about. In other words, when the bulls get on a roll like this, they tend to stay on a roll.
But (c'mon, you knew that was coming, right?)… Everybody on the planet is nervous right now – especially now that Cyprus appears to be blowing up. The macro bears (including more than a few big hedge fund names) are more than a little concerned about those short positions that have been costing them big money this year. And then the bulls are nervous because everybody knows how this type of joyride to the upside tends to end.
If memory serves, the type of relentless rally that we're seeing now, where it is next to impossible to “get in,” usually ends with a “whoosh” to the downside. In other words, these short-term momentum surges tend to either end with, or be interrupted by, a big, bad, downturn, which often leads to a momentum run in the other direction. As such, anybody long the market right now is probably getting a little anxious. And the key question this morning is if Cyprus will be the trigger for this type of move.
So, now that the Dow's 10-day winning streak is over and the S&P 500 is within a stone's throw from a new high, it is probably time to take one of two tacks. (1) Investors can decide that they've got history on their side and bet that any corrective action that appears in the near-term will be short and shallow. Or (2) you can be proactive and decide to prepare for the coming bear raid.
For those choosing option one, there really isn't much to do here. Probably the biggest thing is to be prepared to watch the action closely during the upcoming correction. You will need to be on the lookout for signs that your thesis is wrong. We'd suggest watching key support levels such as 1480 on the S&P 500. A breach of this level would mean that the correction would be exceeding the 5% level (from Friday's closing price, that is), which would be a very simplistic method of confirming that the decline may be turning into something more than a garden-variety pullback within an ongoing bull move.
For those choosing option two, you will probably want to start taking proactive action – and soon. The reason for taking action sooner rather than later is simple: The next decline will likely involve a negative catalyst or trigger. As such, once the catalyst occurs, EVERYONE looking for such a trigger will jump on the short side at the same time. Thus, the time available to react to the move is likely to be very limited.
Five Proactive Methods for the Upcoming Correction
1. Reduce Your Beta
The first way to play for the correction that nearly everybody in the game is looking for is to reduce the beta in your holdings. In English, this means that it is probably time to take your foot off the gas pedal a bit.
According to Wikipedia, “beta” is defined as follows: In finance, the Beta of a portfolio is a number describing the correlated volatility of an asset in relation to the volatility of the benchmark that said asset is being compared to. This benchmark is generally the overall financial market and is often estimated via the use of representative indices, such as the S&P 500.
If a portfolio strategy that you employ tends to outperform – especially during rising markets – then it is a safe bet that said strategy has a fairly high beta. The idea here is to reduce the beta of the strategy by raising some cash with the goal being to bring the beta down to 1 or below.
Here's an example. In our “Insider Buying Strategy” we buy stocks that corporate insiders (employees that are required to notify the government when they buy their company's stock) are buying – but only when they are buying heavily. (In short, this tells us that something is “up” with the company.) We take a concentrated approach in this portfolio, meaning that each holding is a 10% position. Such an approach has performed quite well and has outperformed the market handily. However, we have also learned over time that such a concentrated approach will be much more volatile than the market – especially during corrections.
So, given this knowledge and the fact that the market is very overbought, we have been raising cash recently. Currently we have more than 30% on the sidelines. This is due in part to the market environment and the fact that there have been very few stocks that meet our buy criteria of late. The goal here is to “take the turbo” off of the portfolio for a while in an attempt to retain the healthy lead we've got on the S&P index this year.