Recession, Bear Market Planning, How to Protect and Defend

Bear Market Planning

(Ed. Note: “Erica” is back today…if you missed the previous story about Erica, you can read it here)

Warning Signs

I’m popping in today for “Typhoid Jeff” to catch you up on a series of warning signs and technical details I think you need to pay attention to in the coming weeks; then, I’ll give you some recommendations for what to do.

First, as I’d written previously, we avoided a bearish signal using Dow Theory back in December as the Dow Transports “confirmed” but the Dow Industrials did not.

Dow Transports have set up a bearish shift again here in April (lower highs, lower lows); it remains to be seen whether the Dow Industrials will also confirm.

Here is the chart on the DJT or Dow Jones Transports:

bear market planning

Note the failure in late March to match or top the high at 16,400, while the weekly lows from January through April have made lower lows.

Here’s the Dow Jones Industrials:

bear market planning

A weekly close above 34,9 – 35,2 in the DJIA would fail to confirm Dow Theory. 

A weekly close below 32,950 would turn Dow Theory bearish.

The Yield Curve Returns

Following the initial inversion of the Yield Curve, a significant technical bounce occurred, from minus 7 basis points to nearly 40 basis points. The curve has since retraced 50% of that bounce and hovers below 20 basis points again.

bear market planning

Initial theory behind that bounce was that the bond market did not believe the Fed has the conviction to raise rates at every meeting in 2022; nor that the Fed will get anywhere near 3% Fed Funds rate by the end of the year.

That said, I now view the probability of a 75-basis point rate hike as greater than 50% when the Fed meets next week. 50-basis points is the minimum hike we would see next and would lead to little market reaction.

75-basis points would be a shock to the markets and likely lead to intense selling pressure…

Which brings me to the:

Danger Zone in S&P 500

While the S&P 500 is hovering around -10% for the year, we see two critical levels on the chart, neither of which are promising. Given current economic conditions, the challenge for you as a trader or investor is this:

Risk to the downside is greater than opportunity for upside.

Presently, we have no catalyst for rising markets. Inflation, interest rate increases, slowing global conditions, increased commodity prices … all are increasing the risks to primary support in the major indexes.

While it is true – as we have said – economic conditions are not suggesting a recession, a recession is not necessary for a technical bear market.

First, current support around 4,170-4,150; secondary support around 3,850. Long-term support (aka “disaster”) is ~3,550.

recession

If the S&P 500 should close below 4,170, that increases the probability of 3,850. That move alone would put the S&P 500 in bear market territory (-20% on the year). 

A collapse in the S&P 500 to 3,550 would yield a further -15 to -17% drop from current levels.

I think you should remember this: markets ALWAYS recover.

The Fed is still the greater risk to the market and is also the market’s hope. Things the Fed could do in the future, should recessionary or bear market conditions occur or persist:

Delay or reduce expected rate increases

Cut interest rates

Delay or kill Quantitative Tightening (QT)

Restart Quantitative Expansion (QE)

Any or all of those would shift the market back toward a bullish or recovery state – but we’re likely talking about 12 months from now, at a minimum.

Hedging Concept (NOT A RECOMMENDATION)

If you’re not following the SPY or SPX options chains, you should add this to your watchlist. Use SPY if you’re a smaller or more frequent trader; use SPX if you have more capital to trade.

I recommend SPY because the premiums are more reasonable for people with smaller trading accounts. Start watching volume and open interest between 350 and 400 in the weeks ahead. You’ll be surprised to see how high volume/interest is in these lower levels, consistent with the chart above for the S&P 500.

The options market is telling us something.

Hedging using options means buying options, not selling them. Your objective is creating capital gains on the option to help offset paper or real money losses in your portfolio.

Look forward one week to one month to gauge prices (premium)

6May22 SPY Puts:
Strike: 380 ($1.04)
Strike: 400 ($2.64)

27MAY22 SPY Puts
Strike: 380 ($2.04)
Strike: 400 ($4.35)

(Premiums are in parentheses as you would incur a net debit for buying premium versus selling premium).

Example of capital allocation:

$150k portfolio, hedging allocation no more than 10% total (not one position) = $15k max allocation to hedge.

5% max position on $15k capital (use the hedge allocation, not your full portfolio) = $750 max

That $750 would allow you between 1 and 5 contracts per trade for the options listed above. Alternatively, you could spread yourself across expirations, or use any of the various options spread strategies

Your goal should be 50% or greater capital gains (I won’t stop you if you want to be greedier).

380 6MAY22 @ $1.04 = 6 contracts ($624 capital)

$624 * .5 = $312, or .52 per contract as your minimum target.

Remember – if the option expires worthless, you lose your premium paid ($624), but that’s insurance (nobody likes insurance, I know) of less than one-half of one percent of the $150k portfolio.

If the S&P 500 fails to hold above 4100, those strikes are the most traded right now and therefore likely to be the most profitable in the next 1 to 3 months.

Looking ahead to the July 15 expiration, there is mass trading volume between 350 and 380, just like the S&P 500 chart (again). That same 380 Put with the July 15 expiration is currently trading for $6.46 per contract.

Final Thoughts

Your first thought will probably be to run to the sidelines. Pull your money out of the market and just wait it out.

The first problem with that approach is the value of your money (it’s worth $1.00 minus inflation, so about $ .93 for every dollar). 

The second problem is the increase to cost-of-living expenses – the basics, food, gas, housing.

Which means, your money is worth less while it costs more to maintain your lifestyle.

Over the next few weeks, our focus will be stock and options strategies to defeat a bear market and higher inflation. Don’t run to the sidelines just yet.

 

John Hutchinson
Traders Reserve

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