This is the third cautionary report I’ve written on the stock market in six weeks. The last time I focused this heavily on the stock market was in early 2009. Back then, I was making a point to everyone who’d lost their shirt on the way down that employing the leverage provided by stock index futures contracts would be a great way to recoup some of their lost funds when the market bounced. This week, we’ll discuss the same strategy only in reverse. I’ll explain how to use leveraged futures to protect your equity portfolio ahead of time in case you haven’t taken the appropriate actions.

Everything that I’ve written over the past several weeks regarding the stock market still holds true. Quoting from our December 5th article, “… we have reached valuations that bode poorly for long term investing. Research abounds on the usefulness of long-term valuation models. Very simply, expecting these returns to continue through long-term investment at these valuations would set an historical precedence. Anything can happen in the world of markets but the odds clearly show that bull markets do not begin when the P/E ratio of the S&P 500 is above 15. The S&P 500’s P/E ratio currently stands above 19 and Nobel Prize winning Yale economist Robert Schiller’s cyclically adjusted price earnings (CAPE) ratio is over 25. Both of these will continue higher as long as the equity markets continue to climb. Neither is sounding the, “Everyone to cash,” alarm bell. Their history simply suggests that it would be foolish to expect these multiples to continue to climb and climbing P/E ratios are necessary for stock market growth.”

Coincidentally, the market is trading exactly where it was when I wrote that and after Friday the 24th’s action, we are in fact sounding an alarm bell. Friday’s action sounded a technical alarm based on the 90/90 rule. In short, 90% of the stocks in the S&P 500 closed lower for the day and 90% of the volume was on the downside. This analysis was originally publicized by Lowry’s Reports in 1975 and has been appropriately updated over time. The general market response is for an upward blip for a few days to a week followed by continuation of the selloff. This typically signals a momentum swing and could very well be the catalyst that brings the market back in line with long-term valuations.

The single most common phrase I hear for peoples’ failure to take protective measures for their portfolio is, “I don’t want to pay taxes on anything I have to sell.” The key to using stock index futures as a hedge against your portfolio falling with the broader market is the cash advantage that allows their low margins and high leverage to be put to work for you. The e-mini S&P 500 futures contract is one of the most liquid markets in the world. The face value of the contract is $50 multiplied by the index price, currently 1777.00. Thus the contract is worth $88,500. The margin, which is the amount of money the Chicago Mercantile Exchange (CME) needs on deposit to carry every contract from every market participant is currently $4,510. Both the buyer and the seller of the contract place this amount with the CME. This leaves a margin to equity ratio of approximately ten to one ($88,500/$9,020).

Here’s how it plays out in real terms. First of all, customers need more than the minimum margin requirement to trade. Otherwise, the first day the market closed above the initial entry price, the customer would be issued a margin call by the clearinghouse to make up the difference. Therefore, I suggest allocating enough capital for the minimum margin plus enough additional cash to cover general market fluctuation or, to a point that the trade becomes invalid and the hedge should be removed. In this case, I’d use the recent market highs of 1846.50 as a price that would invalidate the hedge’s necessity. The math works out as follows; $4,510 for margin plus $3,475 to allow for market movement from 1777 to the high at 1846.5 equals a necessary beginning cash balance of $7,985. This is the amount that’s needed to hedge $88,500 worth of the S&P 500 Index against further declines.

If we do get the 10% correction that we discussed in our January 16th letter, the cash balance in your futures account will have grown to $13,760. This would offset the loss incurred by your equities account without forcing you out of any positions or, leaving you with any capital gains tax to pay.

Finally, this is one case where a leveraged ETF simply won’t provide the same bang for the buck. There have been many studies that track inverse leveraged ETF’s against the underlying index and the research consistently shows that they fail to capture the same percentage gains on big down days as the futures markets on which the ETF’s are based. This is one of those times when trading and investing are best done via two separate vehicles.