Do you remember the market crash of 2020? Well me neither! We had one of the fastest recoveries on record, and in a span of 2 years the market has doubled in value! This has most investors on their feet worrying about a correction which might be on the way.
Interestingly enough, every time the market has doubled in value, there has been a major correction. While we like to think more systematically and do not like to rely on these calendar anomalies, it is an interesting observation indeed.
So everybody wants to know, is the market going to have a correction anytime soon?
At Peak Capital Trading, we rarely rely on feelings and intuition and like to have a systematic approach towards most of our decision making. We are a net long fund and have to make decisions on direction of the market, because our investor’s funds are at risk. So naturally, during the time where the markets feels toppy, we have to adjusts our portfolios accordingly.
In this article, I will share with you some key signs and signals which shows a correction, or a consolidation might be on the way and how to hedge your portfolio against it.
I like to break this thesis down into three main categories:
- Strength in the Healthcare sector
- Decline in most economic data
- Uptick in the VIX.
— Strength in HealthCare Sector
One of the key indicators we often look for to know where we are in the business cycle, is to look at sector performances. We believe the market as a whole is semi efficient and sectors are often a leading indicator of where we are in the business cycle.
As an example, in early stages of bull market where the economy is expanding fast, consumer discretionary and cyclicals do much better than non cyclicals and utilities. The reasoning behind this is simple. In early stages of the business cycle, people are making more money and have no problem spending it on brand new Nike shoes or an iphone from Apple! This translates into higher earnings for these companies, which then would lead into that sector outperforming others.
I discuss these cycles in my book in great details, but the graph looks like below:
We see this strong correlation almost always, going back 30 years, back testing the data.
The past month, the health care sector and utilities have been really strong, which signals market is anticipating a contraction in the GDP.
By no means I am predicting a recession, but I do believe just looking at what sectors smart money is flowing into, we can tell that the market is pricing in a correction.
Now whether or not this correction actually happens, is a whole different topic, but this circulation towards utilities and health care, acts as a signal for risk off mentality.
— Decline in Most Economic Data
One lagging indicator is often the economic data that comes out monthly. Paying close attention to these data can often assist investors with their portfolio allocation.
Economic data of July are coming out this month and it all is pointing at the fact that the economy peaked in June. Some major signs are slow down in retail sales number as well as decrease in PMI. Lumber prices are now negative for the year which signals a potential slow down in the housing market and treasury yields continue to tick lower while bond prices are on the rise. All of this data is signaling risk off in majority of the market.
— Uptick in the VIX
The third and final reason I believe the correction might be on the way is the increase in 30 day implied volatility of S&P500. VIX is one of the key indicators that many, even veterans in the markets do not understand very well. Everyone knows that VIX is Wall Street fear gage, but not many people know the dynamic behind pricing of the VIX.
VIX is the 30 day implied volatility of S&P500. Its price is the output of the option volume and prices that are being bought and sold on S&P500. When the fear goes up in the market and investors start buying puts for hedging purposes, this impacts the skewness of the implied volatility curve of the S&P and causes an uptick in the VIX.
In the past few days we have seen major upticks in the VIX, which is signaling the implied volatility in the market is rising.
History Doesn’t Repeat Itself, but it Often Rhymes
Whether you are a quant shop in Wall Street, or an individual investor with limited funds, no one knows market is going up or down tomorrow. All we do is try to look at the data and make educated guesses of what might happen in the upcoming months.
While by no means I am predicting a crash or doomsday, I do believe the data is pointing towards a 5 to 10% correction in the upcoming months.
Investors could hedge their positions by buying protective puts, or running bear spreads on SPX or SPY or simply by going long calls on VIX itself.