Last night’s 500 point drop in the DOW brings back memories of 2008. Prices slicing decisively through the 200 day MA of the SPX on Tuesday, Aug 2 already sent shivers down the spine of technical analysts everywhere. Yesterday’s 60 point plunge confirmed a break of the 27 month uptrend line and neckline of the Head-and-Shoulder pattern that had been forming since the start of 2011 as shown in the 5 year chart of SPX below.
To me the chart pattern today reminds me of December 2007 when the SPX first broke below the neck line of a similar H&S pattern. Back then, we made a decision to simply get out of the market and went 100 per cent into cash as our investment strategy was purely long only then. Since 2008, I have been searching for strategies to profit from a falling market as I expect at least another 2 more down legs in this secular bear market. Some of the bearish strategies that we are using which I have shared on this blog include buying short ETFs like SH which mirrors the moves of the SPX on a daily basis. For example, when SPX fell 4.78 per cent last night, SH went up by a similar percentage as shown in the chart below.
When the right shoulder of the H&S was forming i.e. when prices failed to make a new high, I also made sure all my long stock positions were hedged as I mentioned in an earlier blog post AORD head and shoulders – an example of when to hedge. This time instead of buying XJO puts, I have decided to sell In-The-Money calls which gives me a cushion against roughly a 10 per cent fall in the stock price. Most of our stocks are in defensive sectors so I am not expecting a big fall in those companies even when there is a major correction in the ASX 200 index. Our asset allocation for 2011 is also pretty defensive with less than 50 per cent allocated to stocks. The rest of the funds are sitting in cash, term deposits and other fixed income investments.
If you have not hedged your portfolio, there is no need to panic. I expect the Federal Reserve to announce QE3 or something similar to cause a relief rally. If things play out as they did in 2007-08, there should be a rally (dead cat bounce) back to the neckline (SPX 1260) or maybe even to the back side of the 200 MA (SPX 1290) which might be a good time to put in your hedge. If this happens, I will be adding to our bearish positions if the SPX fails to push back above these resistance points. According to Elliott Wave Theory, the next leg down (Wave 3) would be even bigger than the first leg down (Wave 1 which is from Oct 2007 – Mar 2009) so we may actually see the lows of March 2009 (SPX 666) taken out. Stay safe!