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4 Signs Your Portfolio Isn’t Ready For A Bear Market

By Ronald Delegge In case you didn’t get the memo, global stocks are now in correction mode. And the velocity of the rout has been shocking to seasoned financial pros, not to mention the investing masses. For perspective, the three largest U.S. stock benchmarks – the Dow Industrials (NYSEARCA: DIA ), Nasdaq-100 (NASDAQ: QQQ ), and S&P 500 (NYSEARCA: VOO ) are up between 129% to 258% since hitting their 2009 market bottom. Over the past month, all three U.S. stock benchmarks have shed between 9% to 13% in value. In the context of triple digit gains over the past six years, the current selloff is still just a flesh wound. (See chart below) That, however, doesn’t necessarily mean your investment portfolio is bear market ready. How would your portfolio do in a bear market of -25% losses or worse? Here are four signs that could indicate you’re not ready. Sign #1: The risk character of your portfolio is out-of-whack with reality When the risk character of an investment portfolio is incompatible with your life circumstances, your age, and your ability to tolerate risk – bad things happen. I’ve seen this sad condition consistently with the portfolios that I’ve analyzed using my Portfolio Report Card grading system. Often, it’s only after portfolios have suffered significant losses do people begin to understand their investments are far too risky and not compatible with their situation or themselves. What about the big-mouths who brag they can tolerate a 50% loss or greater inside their portfolio? These types of crash dummies are typically the first ones to jump out of the window. Sign #2: Your portfolio is 100% fully invested Wall Street likes to recommend investment portfolios that are “100% fully invested” because it allows their fee sucking institutions to maximize profits. For the individual investor, however, a fully invested portfolio is bad because it allows zero financial flexibility. For example, when stock prices (NYSEARCA: VB ) are falling, the fully invested portfolio cannot buy stocks at lower prices because it’s fully invested and falling in value just like the rest of the market. On the other hand, a portfolio with cash isn’t forced to sell assets to raise cash in order to buy stocks or whatever else at bargain prices. Take a clue from the world’s greatest investors like Warren Buffett and a tiny minority who always keep cash inside their portfolio for big opportunities. (click to enlarge) Sign #3: Your portfolio lacks a margin of safety The financial advice to “do nothing” – which is now being spewed by a certain mutual fund giant and its famous founder – incorrectly assumes that Joe and Jane Investor have architecturally sound portfolios which are built to withstand not just a friendly market climate, but a nasty one. More pointedly, the dogmatic belief that long-term investing will magically fix a broken and misaligned portfolio is ignorant. All portfolios – large, small, old, and new – should have a margin of safety. Although Graham and Dodd – the founders of value investing – talked about margin of safety in the context of selecting individual securities, it also applies to how a person assembles their investment portfolio. An investor’s margin of safety represents the money they set aside from the two other containers within their portfolio (core and non-core portfolios) to be invested in fixed accounts with principal protection. The prudent investor doesn’t wait until the house has burned to the ground to install a margin of safety inside their portfolio. They do it before the fire. Sign #4: Your portfolio is one-dimensional Any investment portfolio that is built around one asset class, one stock, or one concentrated thing is one-dimensional. And the inherent problem with one-dimensional portfolios is they aren’t adaptable. This means they aren’t equipped to provide satisfactory performance when the market cycle where they once thrived in abruptly changes. One-dimensional portfolios always have higher volatility (NYSEARCA: VXX ), higher drawdowns, and lots of unnecessary risk. And the best way to avoid having this type of poorly built portfolio is to hedge by diversifying across multiple asset classes like bonds (NYSEARCA: AGG ), commodities (NYSEARCA: GCC ), real estate (NYSEARCA: RWO ) and collectibles. Summary Your investment portfolio doesn’t need to suffer catastrophic losses before you know whether it’s able to successfully withstand a bear market. How it behaves today during volatile markets, like we’ve experienced over the past week, is a good predictor of how it is likely to perform during a market environment that is the same or worse. Don’t just observe the warning signs that your portfolio might not be ready for a bear market – but prepare ahead by fixing the flaws inside your portfolio before the storm. Ultimately, well-built portfolios aren’t just multi-dimensional in nature, but they’re designed to perform in any kind of financial climate. Disclosure: No positions Original post

How I Got Burned By Leveraged ETNs

Summary During oil’s first slide earlier this year, I started trading UWTI. Initial success was of course followed by huge losses through the decay in pricing that tends to occur in leveraged funds. Let my experience be a lesson to all those considering messing with leverage. The beginning was great. I made the ultimate mistake. I bought based on what I “wanted” to happen, as opposed to what was “actually” going on. I first bought the VelocityShares 3x Long Crude Oil ETN (NYSEARCA: UWTI ) back in March for $2.24. Less than a month later I sold at $2.53. As the Exchange traded notes kept climbing I bought back in again at $2.82 and sold at $3.20. Suddenly, I was hooked on the volatility of oil ETFs and ETNs. For those who aren’t familiar, ETNs or “exchange traded notes” are sort of the risky cousins of ETFs. They’re unsecured debt securities. They offer a way to get in on the short term moves of whatever the commodity is that it represents. In UWTI’s case, it also offered leverage. Leveraged 3x, I was making basically making 9% off of every 3% gain in the oil index that the ETN tracks. I had some pretty cool returns going off of this bad boy. Oil was recovering from the first time it was down in the low $40/high $30 range. I was having so much fun with the returns that I turned a blind eye to the long term risks involved with ETNs. You see, if you screw up with a leveraged ETN trade, you need to just cut your losses and sell quick. There’s always a catch Canary Cash has a small article touching on the decay involved in leveraged ETNs. If you note Canary’s simplified chart example below, you can see the effects that percentage change has on pricing. ( Source ) Big shoutout to Canary Cash. Back to my downfall… After my success with UWTI, I thought I could keep it going. Oil kept climbing, so I kept buying. My last successful purchase was at $3.42, and I sold at $3.61. Emboldened, I completely ignored the fact that declining rig counts wasn’t having much affect on supply increases in crude. I bought in again at $3.64 believing the sky was the limit. Was it a dumb buy? Absolutely not. The mistake was not paying attention. Due to the big unrecoverable hits you can take on leveraged ETNs, you have to watch them closely and cut your losses quick if you start to lose. I was over confident. My past success had me thinking I couldn’t lose with this wonder security. Two weeks later, oil was in the beginning of its next downtrend…and I was kicking myself for losing a big portion of my previous gains. Did I take my medicine, cut my losses and sell? You all know the answer to that one. I waited. I thought “maybe oil will jump back up and I’ll get it all back”. Did it happen? You know the answer to that one too. UWTI’s chart says it all…. (source: nasdaq.com) Lesson Learned….. Today, UWTI is trading at just around $1. Decay, combined with oil’s downward spiral killed me. I sold last week in pure disgust with myself. It was my first experiment with leverage and it will The lesson I took away is just not to mess with leveraged anything ever again. If you don’t want to heed that warning, at least take my mistake as a clear indicator that if you buy a leveraged security and you lose, just cut your losses so you don’t lose big. Sigh….it still hurts to talk about it. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Time To Short Volatility Again

VXX has spiked in recent days on China fears. But I think the conditions for a short of VXX have been met. Contango has disappeared and that has been a reliable signal in the past. I’ve written several times in 2015 about volatility and specifically, shorting the popular short term VIX ETF proxy VXX (NYSEARCA: VXX ) as I’ve taken the occasion of various spikes to bet on normalization. Last time I wrote about such a trade it was during the July meltdown stemming from the now-distant Greek crisis and that trade returned very nice profits, as you can see below. Well, here we are again as the VXX is spiking once more on China’s woes or any other global event investors can think of. (click to enlarge) My basic premise for entering a short VXX trade is pretty simple; wait for a spike in VXX, assess the reasonableness for a sustained higher VIX level and if there is none, short VXX. It really isn’t more complicated than that. VXX is a great vehicle to short because of its famous contango. It costs money (most of the time) to hold VXX due to contango so the opposite of that is that shorting it has a natural tailwind. This is the second cue for me in knowing when to short VXX and when to wait for a better entry point. But first, let’s assess why the VIX is spiking. Seems to me market participants are up in arms about China’s most recent meltdown and while that’s fine, just like the Greek crisis, I believe fears are overblown here. S&P earnings are also suffering somewhat and the market is losing leadership in a lot of ways so for me, that is a much bigger problem than China’s latest bubble popping. I know there are many people that would disagree with me but I just don’t get it on China. Therefore, the first condition of my short signal has been met; the reason for the spike seems improper and in particular, the magnitude with which VXX has spiked. We’re up double digits in two days on the VXX and for what? The second signal I mentioned is when VXX is no longer in contango, that has historically been a great time to short it. I like to use VIX Central to chart the VIX curve and determine the level of contango because it makes it easy for even novice VIX watchers to understand what is happening. I’ve pulled two charts from VIX Central below to illustrate my point. This first chart is a straight look at the VIX curve. Since the VXX deals with short term VIX contracts, we’re really only interested in the first two months. As you can see, as of yesterday’s close September and October were at exactly the same level and even November and December were only pennies higher than the front month. That means contango has disappeared and when that has happened in the past, it was a great time to short VXX. This chart shows the level of contango between the first and second month VIX contracts for the past several years and as you can see, flat contango and backwardation are rare. But when either of those conditions are met, we are usually due for a sell-off in front month VIX. That means that when we reach the level of contango we are at right now (zero, the red line on the chart), while we may move a little higher, history suggests the odds are heavily in favor of shorting VXX right now. So here’s the setup; the SPY just hit a six month low yesterday and after the beating the market has taken in the last couple of days, I think today will be a flat to lower day. That means VXX will probably be higher on Friday and that is where I will make my short. I will use the recent spike in VXX to short it as I think we are nearing the top of this particular spike. Now, I’ll make my standard VXX trade disclaimer because I don’t want anyone to get the wrong impression. Trading VXX is very risky and extremely volatile and thus, you must understand that the potential reward is high but so is potential risk. Please understand what you’re doing before taking a long or short position in VXX because it moves around a lot and can make or lose you a lot of money in a very short amount of time. I’ve been on both sides of VXX trades and I can tell you it can wipe out a lot of value quickly. The odds are in favor of a VXX short right now and I think today is the perfect opportunity to take a short position in VXX given that the spike in volatility seems overblown. I also think the market is near a base and will rally from here so that is also a favorable setup for shorting VXX. This position is not without risk but given the setup we have now, VXX shorts are heavily favored here. Good luck out there. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in VXX over the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.