How to Protect Yourself From the Stock Market Inflate-a-Rally

By: Jared_Levy

We are now officially in the thick of earnings season, which means added volatility for the marketplace. Splashy headlines like Google’s surprise surge in sales are making the bulls bolder by the day.

And as long as earnings reports continue to at least meet consensus estimates on average, that most likely won’t be the foundation for a correction… yet.

My concern is for the peaks and valleys we could see from this inflate-a-rally. If smart investors have learned anything over the past few years of market volatility, it’s to abide by the Boy Scout motto to always be prepared.

Here are the best ways to arm your portfolio with protection…

It All Comes Back to Commodities

Caterpillar or CAT tractor, as we traders like to call it, has led the Dow in its most recent charge to the upside. Without CAT’s huge upside moves over the past couple of months, the Dow Jones would NOT be where it is today. CAT’s rally has been driven by the ongoing weakness in the dollar and in turn the contrary strength in commodities.

It’s not just CAT that gets a boost from Helicopter Ben’s loose monetary and weak dollar policies, but basically any company with substantial operations in foreign countries whose currency is stronger than ours. Companies such as McDonald’s (MCD), IBM, Coca-Cola (KO), Boeing (BA), GE, Intel (INTC), 3M (MMM) and PepsiCo (PEP) also fall into that category.

Coincidentally, those companies alone account for one-third of all the companies that comprise the Dow Jones. (Most of the others also have foreign exposure, of course.) But even those nine companies, excluding all others, would have an effect greater than 60% of the index because of their high weightings.

It is important to remember that for companies to take full advantage of a weak dollar, they must produce their goods here and ship them to countries with stronger currencies. Also of note is the fact that they should be reporting in U.S. dollars.

So realize that if the dollar makes a sharp trend reversal (which I don’t think will happen soon), many of these stocks could have the wind taken quickly out of their sails and experience a 180-degree shift in direction.

Why I’m Taking the Cautious Approach
A couple of weeks ago, I wrote about the markets still being relatively cheap, and luckily for me, my thesis has been correct. Of course, there are a multitude of inputs and variables I use to determine relative value. One of the most important basic fundamental data points I look at is the price/earnings ratio of the S&P 500, both the trailing history as well as the projections.

As it stands now, only about 12 companies in the S&P have reported their earnings. All of them are showing positive growth (bottom line) compared to last year, with the strongest coming from the materials sector (no surprise there).

It still looks good from a value perspective with the S&P’s collective trailing P/E multiple at 15.42 and the forward just below 14. As I said before, this minimal gap tells me that the expectations for growth are moderate, not super high. When you have higher expectations, you have a greater chance for disappointment; watch the P/E ratios of the individual names you may invest in.

What Every Smart Investor Needs to Keep in Mind
I believe, based on news, earnings calls and macro data, that companies will meet expectations for the most part this quarter, with the high expectation that companies like Netflix (NFLX) and Salesforce.com (CRM) will experience higher volatility because of their high multiples.

But that doesn’t mean we’re entering a full-blown bull rally. We still need to be wary.

Housing and hard assets may benefit from a weaker dollar, but the question is whether it is really good for the American consumer and companies that have the bulk of their business here. For you as an investor, when the market seems to get a little bit overheated, you might consider moving a portion of your stock investments into more defensive names like Johnson & Johnson (JNJ), Altria (MO), McDonald’s (MCD), Proctor & Gamble (PG)… and even alcohol company Diego (DEO). Everyone tends to drink more when times are bad!

While they may not be the sexiest, their lower betas can offer you shelter ahead of a downturn in the market. Once the market looks like it’s ready to resume its rally, you can trade those boring, low-beta stocks in for the BIDU’s and AAPL’s that will accelerate your portfolio on the way back up.

Remember: Be cautious over the next couple of weeks. My instincts and statistical measurements point to at least a temporary end to the euphoria.

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By Jared Levy
http://www.taipanpublishinggroup.com/

Jared Levy is Co-Editor of Smart Investing Daily, a free e-letter dedicated to guiding investors through the world of finance in order to make smart investing decisions. His passion is teaching the public how to successfully trade and invest while keeping risk low.

Jared has spent the past 15 years of his career in the finance and options industry, working as a retail money manager, a floor specialist for Fortune 1000 companies, and most recently a senior derivatives strategist. He was one of the Philadelphia Stock Exchange's youngest-ever members to become a market maker on three major U.S. exchanges.

He has been featured in several industry publications and won an Emmy for his daily video "Trader Cast." Jared serves as a CNBC Fast Money contributor and has appeared on Bloomberg, Fox Business, CNN Radio, Wall Street Journal radio and is regularly quoted by Reuters, The Wall Street Journal and Yahoo! Finance, among other publications.

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