Markets rarely move up in a straight line and they ALWAYS correct. This time it will be no different. The question is what are you prepared for and what can you control?

Since March 2009 the stock market has been on a tear moving higher by more than 80% from the lows on the S&P 500. Is it time to finally celebrate the end of the Great Recession? Are we in the clear?

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Well, the stock market certainly thinks so and as a forward looking gauge things are looking good for the months ahead. But, that does not necessarily mean things are looking good for the market – for the economy definitely.

The market at current levels may not be overvalued from a historical perspective – after-all it is still trading at levels we saw more than two years ago. The NASDAQ Index is still trading at half the level it reached in 2000 during the Internet bubble.

So, we could have room to run, except that there is one indicator that continues to flash danger in the wings. That indicator is the VIX or Volatility Index. Under 16 now, the VIX is screaming that investors are complacent. People are once again looking for higher returns, leaving the fold of conservatism once again. This is where trouble usually begins as risk appetites rise. While there is little doubt that the VIX is in “correction territory” we’ve seen this story play out many times before and the outcome, while certain, is not always punctual!

The VIX can remain at levels as low as 15 or go even lower to 10 or 9 without a major or minor correction. The VIX signals investor sentiment which we then interpret as bullish or bearish. Under 20, the VIX signals complacency on the part of the investor. Under 15, investors are entering the realm of extreme comfort with the market. Under 10, investors have lost sight of reality and the market is set for a major correction. So, you see, we are still not at the euphoric stage yet, but most corrections have not occurred from euphoria, rather from the stage between comfort and the onset of euphoria…about two or three points lower than where we are.

That means you need to be extra vigilant right now and you should begin to pare back positions in stocks. Complacency unfortunately can last for a long period of time. There have been stretches of almost two years where the VIX has remained low and still no correction. But, the lower it goes and the longer it stays there, the more likely a correction of great magnitude will occur – be warned!

How to Prepare

The first thing that you need to do is to set stop-losses on every position you own, whether real or mental. A stop-loss is the price that you tell your broker or punch in on you online account at which you want out of a position. It is meant to preserve capital or profits in the event of a market decline – an orderly decline. If the market experiences a violent crash, the stop-loss becomes a market order and you will get the bets “fill” even if that is below your stop-loss.

You could begin to pare back positions now and use long-term options as a substitute. For example if you have huge profits or a position in a gold stock, you could sell all or part of it and replace the holdings with a gold LEAP option (A LEAP is a Long Term Equity Anticipation security) which does not expire for one or even two years. Entering the LEAP position will cost you between 10% and 20% of the underlying share price, allowing you to take 80% or more of your cash off the table.

Prepare a list of stocks that you would WANT to own so that you are not caught without a plan during a correction. Of course, you will need cash on hand then…so get some cash ready now. It is during corrections and times of panic that stocks are cheap.

The market is looking quite healthy but maybe not for the right reasons. Lots of cheap money is once again flowing into the markets making it appear that things are rapidly getting better. For stockholders it’s been a grand two years. For many others who make up the backbone of the population, the story still remains grim. And that is why you should take a more sober approach to what is happening. Unemployment and housing are the two boogiemen that are still at work. The housing bubble, if it is anything like any past bubbles, may take a decade or more to unwind – The NASDAQ Index is still off 50% a full decade later…and tulips, well, they are nice flowers.

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