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Investing in a Volatile Market

Written By Briton Ryle

Posted October 10, 2014

After years of minimal volatility in U.S. stocks, we sure are getting more than our fair share now. In just the last 10 trading days the S&P 500 broader market index has swung at least 5 times – down 2.75% from September 30 to October 2, up 2.5% from the 2nd to the 6th, down 2.75% again from the 7th to the 8th, up 2.25% on the 8th, and down 2% on the 9th.spinning top market volatility

Have you ever watched a spinning top tip over? It starts swinging more violently from side to side just moments before coming down. Is this what the markets are doing? Are their wild gyrations an indication they are about to tumble?

Famous shareholder activist Carl Icahn believes so. In fact, he is so convinced that a severe market correction is “definitely coming” that he announced in a CNBC interview he is shorting the entire S&P 500 index through the most heavily traded SPDR S&P ETF (NYSE: SPY).

“I’ve been quite concerned for the last year or so,” Icahn revealed. “But we have a hell of a lot of stock in our portfolio so you sort of root for the upside.”

Now before you start dumping everything you own and shorting the market like Icahn is, note the entirety of what he said. Although he is adding a short position on the SPY, he still owns “a hell of a lot of stock”.

Investors need to appreciate one very important thing about short sound bites and quick quotes from interviews… they are meant to draw your attention, they are not meant to trade on.

Certainly the experienced investors aren’t trading on Icahn’s interview clips. “We haven’t seen any indication that there has been a ton of shorting activity in the midst of this volatility,” informed Joe Bell, senior equity analyst with Schaeffer’s Investment Research.

In fact, rather than sell and head for the hills, investment advisors are calling our attention to a buying opportunity just around the corner, if it isn’t here already.

“Unless there is a major deliberate event that emanates from some foreign nation, the stock market correction is closer to the end than the beginning,” opined Kirk Spano, registered investment advisor and founder of Bluemound Asset Management, LLC. “If you have been holding a lot of cash, it’s time to start looking for investments.”

But if this correction is already near the end as Spano affirms, why is Icahn shorting the SPY? If Spano is putting his cash to work, where is he looking to invest? Let’s answer those two questions one at a time.

What is Icahn Up To?

By revealing that he still owns “a hell of a lot of stock”, Icahn is confirming that his shorting of the S&P broader market is merely a hedge against his current holdings, for if he were truly bearish, he’d be selling “a hell of a lot of stock” to lock-in profit and then wait to buy back later. That he isn’t selling his holdings but is merely adding a broader market short positions means it is nothing more than a short-term hedging strategy.

Such a hedging strategy works only if you hold stocks that are more volatile than the S&P 500, namely stocks with a high beta. Simply put, beta measures a stock’s volatility as compared to the S&P 500 index, which has a beta of 1.0. Call it the standard against which other stocks are compared.

A beta greater than 1.0 means the stock will generally rise and fall more percentage-wise than the S&P, while a beta less than 1.0 means the stock will generally rise and fall less. But the beta metric is even more useful than that, as it measures by how much a stock’s volatility differs from the S&P’s.

For instance, a beta of 2.0 means that for every 1% the S&P moves, the stock will move twice as much, or 2%. A beta of 1.5 means it will move 1.5 times as much as the S&P (S&P moves 1%, stock moves 1.5%). A beta of 0.25 means it will move one quarter as much as the index (S&P moves 1%, stock moves 0.25%). Etc.

While we don’t know exactly what stocks Icahn owns, we do know he is not the sort of investor who plays it safe, but likes to make big bets. If he owns high beta stocks, then shorting the SPY works fine as a hedge – for if he is wrong and the market moves up, his high beta stocks will win more than his short SPY loses.

That Icash is choosing to add a short position on the S&P index while still holding “a hell of a lot of stock” shows it is just a short-term hedging strategy, not a long-term investment plan.

What is more, very few in the marketplace are imitating Icahn’s hedge. “The cost of borrowing [shorting stock] remains at very low levels and would be in the area of ‘general collateral,’ which means very low rate and very easy to borrow or short,” revealed Tim Smith, executive vice president at SunGard Astec Analytics, which tracks the amount of securities that are lent out to investors who want to short them.

“The amount utilized of available supply is around 7%,” Smith added, “so there is plenty of room for borrowing to take place should it be required.” In other words, very few investors seem to be following Icahn’s lead in shorting the SPY, and neither should we.

Why? Because the Fed has our back. Or as Spano puts it, “The Federal Reserve has done a pretty good job of navigating a very misunderstood set of problems.” Rest assured, the current Fed is one of the most dovish in history, and it will not allow another market implosion like the one of 2008-09.

Instead of shorting the market, here is where Spano recommends investors put their money.

What is Spano Into?

The first thing Spano wants to make clear is that while he is optimistic regarding the markets’ future, he does feel now is a good time to shift some of our allocations.

“In the past few months the world has seen a different dynamic start to emerge,” he wrote to investors yesterday. “Earlier this year, anticipation of the end of quantitative easing (QE) started to turn the dollar upward. That increase in the value of the dollar, now with the end of QE just days away, has brought about the volatility in the stock market.”

It is undeniable that the Federal Reserve’s easy money policies and stimulus programs have lifted equities a little higher than normal (some would say a lot higher). As that stimulus ends (QE3’s monthly bond buying is set to end this month or next), the markets will naturally adjust to less easy money.

The markets are also adjusting to a stronger dollar which hurts exports and lowers the profits of U.S. companies with a large involvement in overseas markets, since it costs them more to convert their foreign profits into USD.

So what does Spano recommend investors do in this environment? “Selectively selling stocks with stretched valuations is clearly a smart idea as momentum has already slowed,” he writes. “Many stock funds should also be sold as broader market valuations, especially in certain sectors like utilities, are generous and likely to be less generous in a firmer dollar environment. Reduce stock fund exposure to 50%, with 25% in a short-term bond fund and 25% in a stable value or money-market fund within (your) 401(k).”

Essentially, anything that heavily depends on Fed stimuli and ultra-low interest rates should be sold, including utilities. Why utilities? Because they are heavy borrowers, constantly issuing new bonds. Now that the Fed will begin raising interest rates in the near future, debt will become more expensive, cutting into utilities’ profits, with their stocks adjusting downward.

Instead, Spano recommends short-term bond funds in particular, since their shorter maturities (typically less than 5 years) allow them to be rolled over into newer bonds more frequently. As the Fed raises rates over the course of the next 5 years or so, bond funds will be rolling older lower interest bonds into higher interest bonds, generating more income which increases the dividend paid to the funds’ shareholders.

Two viable short-term bond funds to pick from are the SPDR Barclays Short Term High Yield Bond ETF (NYSE: SJNK) which holds 0-5 year bonds and pays monthly dividends yielding 5.8% annually, and the iShares High Yield Corporate Bond ETF (NYSE: SHYG) which also holds 0-5 year bonds and pays monthly dividends yielding 4.61% annually.

In addition to short-duration bond funds, investors might consider floating-rate bond funds whose bonds may not necessarily be of short-duration but are of variable interest rates. As the Fed increases interest rates over the coming years, these floating-rate bonds will adjust to higher rates and generate more income.

Three viable floating-rate bond funds to select from are the Nuveen Floating Rate Income Fund (NYSE: JFR), BlackRock Floating Rate Income Strategies Fund Inc. (NYSE: FRA), and Eaton Vance Senior Floating-Rate Fund (NYSE: EFR), currently yielding from 5.8% to 6.4% per year.

Timing is Nothing (Sort of)

Just keep in mind that interest rates will likely still remain low for another year or so until late 2015 or possibly even early 2016. Bond funds will likely not start appreciating until two or three months before rates actually begin rising. But who among us honestly believes he can time the moment right on the button? Timing is nothing to get all worked up about, because you just can’t win the timing game.

Better to be early to the party than late for dinner. Or as Spano puts it, “the calendar will fix for you even if you don’t buy the exact bottom, which you almost certainly won’t.” These are long-term investments where the “calendar” will make up for any premature entry on our part.

There’s one more long-term trend Spano believes the calendar will help us with… “The trend I am buying now, and wrote about last week, is natural gas,” he reveals. “The shift from coal to natural gas and eventual export of natural gas to our allies is a long-term trend that is just beginning.”

The largest natural gas ETFs include the United States Natural Gas ETF (NYSE: UNG) and the First Trust ISE-Revere Natural Gas ETF (NYSE: FCG). But here again, timing is never perfect. If you enter a little early, remember that time is on your side with natural gas and short-term bond funds.

Joseph Cafariello