On Tuesday, the DOW gave up 369 points or 2.92% while the tech-laden NASDAQ and small-cap Russell 2000 both plummeted by over three percent in a major sell-off. The decline in stocks followed a down day on Monday and clearly suggests capitulation. With the current bearish sentiment, we could see another test of lower support. Rising fears towards the condition of the economy and credit markets is the reason.
In addition, with the declining environment of interest rates, there is downward pressure on the U.S. dollar, which has been losing ground and has been discouraging foreign investors in U.S.- denominated investment assets. There continues to be speculation that countries will start to hold physical gold instead of the U.S. dollar. A country to watch is China, which holds about $1.43 trillion in foreign reserves and much of it in U.S. bonds, and may look to diversify outside of the U.S. dollar. This is a real threat that needs attention because of its potential negative impact on U.S. bond markets. If this should happen, U.S. interest rates may be pressured to rise in order to attract bond investors, but then we do not see this as a viable alternative due to economy.
As an investor, the prudent thing to do at this time is to be careful and wait on the sidelines until the selling subsides and then look for bargains.
In the meantime, there are also several things you can do to safeguard your capital. I have discussed these in previous commentaries, but it is important to be reminded.
I have always been a big believer in taking some profits off the table, especially when gains have been significant. I continue to believe in taking some profits on a portion of a position as the stock trends higher. In doing so, you would lock in some profits and make your position less vulnerable to the selling we are seeing.
Another strategy would be to make sure you have stop-loss orders in place to protect against a downside move. As each stock rises, move the stop-loss higher. I advise setting actual physical stop-loss orders rather than mental stops, as it removes any unwanted emotion in the trading process.
A third strategy would be to buy put options on a stock that you have a major position in or put options on an index that reflects the composition of your portfolio. Put options will help to minimize a downward move in the stock or market. In down markets, you can also write covered calls on stocks to generate premium income.