Is the Federal Reserve About to Crush Markets? How to Prepare

Source: Thinkstock

Source: Thinkstock

There is no question that the market seems to be getting a bit frothy here as the Dow Jones Industrials (NYSEARCA:DIA) flirts with the 17,000 mark. This week, we have edged down most days. A lot of the explanation for this revolves around the Federal Reserve. We have seen gold and silver move significantly higher in the last month while stocks have been rather stagnant as a whole. This is in part due to growing fears surrounding the Federal Reserve’s policies. There is fear of higher interest rates, fear of a reduction in asset purchases, and fear that one or two big selloffs could trigger a massive correction on the order of 15 to 25 percent or more.

Let’s face the music here: The wildly accommodative super low interest rates and bond-buying program does risk triggering the next world financial crisis. A lot of investors are trying to write this off, but I argue the writing is on the wall. The fact is that monetary accommodation while certainly boosting our markets in the short-term is getting to the point of the longer term financial stability of our system. I cannot stress enough what this means for asset markets and credit markets — it’s a concern. There is no telling when the next major selloff will be, but this frothy market action is a concern.

Let’s look at the data here. The Federal Reserve’s balance sheet stood at $4.33 trillion as of this week, which up nearly $900 billion on the year before. It has ballooned since the purchasing began in 2008. This is a systemic risk to its stability, but what about the risk to markets when they cease purchasing? Investors have been taking profits slowly since the Fed announced it would cut purchases to only $35 billion a month in mortgage products, and the Fed is hinting that it will soon raise interest rates. That is not good for markets. So what can we do to prepare? To take some protective action, traders may want to put on some bearish positions. Those who are bearish could consider selling stock, selling covered calls on their positions, shorting stocks, or buying puts. While each of these approaches has its respective benefits and risks, in this article I want to highlight several funds that could provide great short-term returns in the event of a market sell-off.

iPath S&P 500 Short-Term VIX futures ETN (NYSE:VXX) The VXX is a tool that tracks the Chicago Board Options Exchange Market Volatility Index, or the VIX, which is a popular measure of the implied volatility of the S&P 500 market index. The VIX is a measure that is supposed to represent the market’s expectation of stock market volatility over the next 30-day period. The VXX is a fund that is one of the better ways to track the VIX (which is not directly available to invest in) than many of the other leveraged volatility ETNs. The VXX as an investment seeks to “replicate, net of expenses, the S&P 500 VIX Short-Term Futures Total Return Index. The index offers exposure to a daily rolling long position in the first and second month VIX futures contracts and reflects the implied volatility of the S&P 500 index at various points along the volatility forward curve.” As part of this approach, the index futures roll continuously throughout each month, from the first month VIX futures contract into the second month VIX futures contract. While volatility has not been an attractive play of late, it has been gaining steam. The VXX recently underwent a one-for-four reverse split to increase share value. The fund has an annual expense ratio of 0.89 percent, and is currently trading at $29.00. It has a 52-week trading range of $28.59-$85.52 (please note this range does not account for shares reverse splitting.)

Direxion Daily S&P 500 Bear 3x ETF (NYSE:SPXS): The fund can be considered for heavily leveraged bearish exposure to large cap stocks. The Direxion Daily S&P 500 Bear 3x ETF, formerly the Direxion Daily Large Cap Bear 3X fund, seeks daily investment results before fees and expenses of 300 percent of the inverse of the price performance of the S&P 500 Index. As with other funds, there is no guarantee the fund will meet its stated investment objective and is subject to slippage as described above. The fund also has a higher 1.14 percent annual expense ratio. The Direxion Daily S&P 500 Bear 3x ETF management team likes to create short positions by investing at least 80 percent of its net assets in: futures contracts; options on securities, indices and futures contracts; equity caps, collars and floors; swap agreements; forward contracts; short positions; reverse repurchase agreements; ETFs; and other financial instruments that, in combination, provide leveraged and unleveraged exposure to the S&P 500.

Given this approach, in times of market sell-offs, the Direxion Daily S&P 500 Bear 3x ETF will deliver outsized returns. Thus, this fund should be considered by those who seek to profit from panic that could result from a fast sell-off that jolts the market. The Direxion Daily S&P 500 Bear 3x ETF currently trades at $26.14 a share. The Direxion Daily S&P 500 Bear 3x ETF has average daily volume of 2.1 million shares exchanging hands. SPXS has a 52-week trading range of $25.69-$54.90.

Direxion Daily Small Cap Bear 3X Shares (NYSE:TZA): The Direxion Daily Small Cap Bear 3X ETF management seeks daily investment results of 300 percent of the inverse of the price performance of the Russell 2000 Index that tracks small cap stocks. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership. TZA actually does not invest in equity securities or stocks. What the Direxion Daily Small Cap Bear 3X ETF does is creates short positions by investing at least 80 percent of its net assets in financial instruments to provide leveraged and unleveraged exposure to the small cap index and the remainder in money market instruments. The Direxion Daily Small Cap Bear 3X ETF also recently underwent a reverse split in response to the bull market powering ever higher. It now currently trades at $14.28 a share on average daily volume of 23.1 million shares. The Direxion Daily Small Cap Bear 3X ETF has a 52-week range of $13.96-$32.00.

Here’s the bottom line: We have an aging bull market. We have a market that is now showing signs of exhaustion. The action has been frothy of late. Catalysts that drove the market higher are being peeled away by the Federal Reserve. Market sentiment is worsening, but we don’t need to dump positions all at once here. A large correction could be brewing and there is evidence that it is more likely. To capitalize on a broader market selloff, beyond the tips I gave in the introduction, I recommend these three funds that do incredibly well during corrections and volatile trading action as insurance.

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