With the stock market coming under increasing pressure as concerns about the viability of the economic recovery rise, several people have e-mailed me asking how they can protect themselves. The short answer is you can, and the more complicated answer is there are several ways to do so — some simpler ones and some that are more complex and better suited for more risk-tolerant investors.
Without question, there is growing concern that the economic recovery is losing steam. While we can point to several economic data streams over as many weeks, headlines on the Web, in magazines and in other publications are raising the issue if not stoking it. In the past week, some headlines have been: "U.S. Needs 'Bright Star' to Stimulate Economy," "Federal Reserve weighs steps to offset slowdown in economic recovery," "CBO tells Obama deficit panel that forecast remains bleak," and "U.S. Jobs Picture Darkens."
On Thursday, we received several new and unsettling updates, including one from the International Monetary Fund (IMF), which raised concern that risks to the speed of the global recovery are mounting. As it pertains to the U.S., the IMF now sees the gross domestic product (GDP) at 3.3 percent in 2010, which is somewhat better than expected. However, the revision is bittersweet, as the IMF expects growth to slow to 2.9 percent in 2011 and 2.6 percent by 2015.
As can be expected, the IMF cited the same underlying concerns that others and I have talked about — the lack of real job growth. According to IMF estimates, unemployment is expected to hold at at least 9 percent this year; while this paints the picture of improvement, we have to remember that the number of people receiving unemployment benefits will contract as those benefits expire in the coming months. Also under the label of "as expected," the IMF warned that the backlog of foreclosures in the U.S. housing market and the weak job market "pose risks of a double dip in housing."
Adding to the IMF perspective, early this week, noted economist Nouriel Roubini shared his view that eurozone growth in 2010 could be "closer to zero" after a volatile second quarter threatens to dash previous estimates of 1 percent. One area to watch will be stress tests administered by the Committee of the European Banking Supervisors for banks in the European Union. If these tests are anything like the ones we had in the U.S. several months ago, odds are investors will put little weight behind the results.
I say this because even though few domestic banks failed their stress tests, halfway through 2010, we already have seen more than twice the number of failed banks and credit unions as we saw at this point in 2009. So far in 2010, there have been 96 failures — 86 banks and 10 credit unions — compared to 45 failures as of June 2009. To put this in perspective, 171 institutions failed in 2009. The reason behind the continued bank failures: commercial real estate market stresses caused by foreclosures.
Turning away from the eurozone to Asia, core machinery orders in Japan fell 9.1 percent month over month in May. This is the sharpest drop since August 2008 and was much worse than the median forecast for a 3.0 percent decline. This follows weak industrial production data for Japan as well as recent negative revisions for the country's April-June quarter GDP expectations and a modest tick up in its jobless rate.
All in all, there are reasons to be concerned, and it makes sense to want to protect gains in the stock market that may have been made over the past few quarters. Another perspective would be to limit one's losses, particularly if he or she needed to be invested. If not, one simple answer would be to build cash and sit on the sidelines until a firmer and less volatile market emerges. That's the simple answer I mentioned earlier.
Another option, one that is more complex and is really suited only for those investors with an investment profile that can tolerate more risk as well as more volatility would be to sell securities short. More on that and its intricacies can be found at Investopedia.com as well as nearly any book on investing in the stock market. Again, it is not for the weak of heart, and while investors can be wrong on a stock and still make money, being wrong when you are shorting a stock can be costly.
But there is another option, again for those who are looking to take advantage of what they think may be weakness in the overall market or in certain sectors and can accept the higher associated risk. For that we turn to exchange-traded funds (ETFs), an area that has exploded in the past few years. As a result of that explosion, there are ETFs to bet on a rise in certain indices and industries as well as capitalizing on what one may think is pending doom and gloom for an industry or index. Arguably, one of the better sources for these types of inverse ETFs that bet against the market, index or industry, like the Ultrashort S&P 500 ETF (ticker symbol SDS) and Short Dow 30 (ticker symbol DOG), is ProShares.
Have I shorted stocks and used inverse ETFs before? I have. Is it for everyone? No. More than a few people like to sleep rather soundly at night, and there is nothing wrong with booking profits and leaving it at that. There is always a bull market out there; after all, having Apple Inc. selling millions of new devices in recent weeks bodes well for someone besides Apple.
• Chris Versace, the Thematic Investor, is the director of research at Think 20/20, an independent equity-research and corporate-access firm located in the Washington, D.C., area. He can be reached at email@example.com. At the time of publication, Mr. Versace had no positions in companies mentioned. However, positions can change.