4 ETFs to Buy to Protect Against Huge Market Losses

May 5, 2015 by 247lee

It has now been six years since the depths of the Great Recession and the ensuing stock market sell-off. The S&P 500 is up over 200% in that period, and we have not had a 10% correction in the markets in over three years, although we came close in 2012. The bottom line is that it will come, and the only thing is when, not if. It may surprise some to know that the current S&P 500 bull market rally is the third longest ever.

In a recent research note, not only does the equity strategy team at Merrill Lynch advocate some rotation, they also say a little retreat could be in the cards as well. By retreating, they mean by raising cash and, perhaps for some accounts, even buying some gold.

Here are the four trades that investors in the United States may want to be very cautious of going forward. With such a long drought since a 10% correction, the markets are overbought. Even Warren Buffett said on Monday that stocks were expensive, just not as expensive as bonds.

The U.S. Dollar

For those who actively have been involved in this trade, it has been a huge winner. Some 85% of all currency transactions across the world involve the U.S. dollar. It is the world’s primary reserve currency, and 25 different currencies are pegged to the U.S. dollar. The bottom line though is that this is perhaps the most crowded trade on Wall Street. And regardless of whether an account actually owns dollars or is short the euro, this is going to end up bad if serious selling starts. There are ways however to take the other side of this trade.

While futures or short-currency approach are possibilities, there is a lower-risk short U.S. dollar exchange traded fund (ETF) option that may make more sense for many investors. That is because short U.S. dollar ETF prevents investors from losing more than their initial investment, and it is also cheaper than directly shorting currencies or utilization of futures contracts. The PowerShares DB U.S. Dollar Bearish ETN (NYSEMKT: UDN) makes sense for investors looking to be short the dollar.

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Real Estate Investment Trusts

These investments, known as REITs, have done exceptionally well since the market bottomed in March of 2009. They combined high income plus a contrarian play on real estate, which at the market lows was the asset that had started the great decline and most people would not go near. Indexes that track the overall REIT market are up over 300% since the lows of 2009 and are just now starting to roll over. The combination of reasonably stable dividends and growth potential off the lows has made them very attractive.

There is one major problem. Rates are going higher, as the Federal Reserve starts to lift the federal funds rate after years of zero interest rates. REITs are an asset class that typically does horrible in a rising interest rate environment. Shorting individual REITs is expensive, and the investor is responsible for paying the short borrow cost and the distribution. A better way is to purchase the ProShares Short Real Estate ETF (NYSEMKT: REK).

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U.S. Treasuries

Obviously this has been a crowded trade for years, and it is a de facto long the U.S. dollar trade as well. While the U.S. Treasury market has been the source of huge gains for investors over the past six years, the bottom line is that we have been living under abnormally and historically low interest rates. If rates were to go back just to normal historical levels, recently issued Treasury debt would get absolutely mauled in the process.

To put things in better perspective, the current 10-year U.S. Treasury bond yield is at 2.16%. On January 1, 1995, the yield of the 10-year Treasury was at a whopping 7.78%, more than 300% higher.

If investors are holding large piles of Treasury bonds that they do not want to sell, or agree that the bonds are overvalued and want to be short, they may consider buying the ProShares Ultrashort 20+ Year Treasury (NYSEMKT: TBT).

High-Yield Bonds

High-yield bonds, or junk bonds as they are called, is another asset class that has done terrific as the Fed has kept interest rates at the historic lows. High-yield debt is typically issued by companies that have a lower credit rating and are unable to be rated as investment grade. Like REITs, they got absolutely destroyed in the aftermath of the huge 2008 to 2009 market meltdown. However, since then, in a desperate search for yield, income investors have bid the bonds way up. In fact, many high-yield ETFs and closed end funds are trading at huge premiums to the underlying net asset values.

While not all high-yield debt is at risk, if rates start to move up fast, there could be a steep sell-off in the riskier debt. Last week $0.6 billion of outflows from high-yield bond funds was reported, according to the Merrill Lynch report. That is the largest amount in 14 weeks. One alternative for investors looking to short high-yield, or hedge positions, is to buy the ProShares Short High Yield (NYSEMKT: SJB).

ALSO READ: 13 Analyst Stock Picks Under $10 With Massive Upside Targets

It is important to note that the Merrill Lynch team did not advocate or suggest buying any of these ETFs in their research report. They simply were pointing out which trades could be in the most trouble and which way fund flows were moving currently. At the end of the day, the markets are very pricey on a historic basis, and while a 10% correction would be painful, it may also clear the decks for a move higher later this year.