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Expecting A Market Slump? Here's Your Second-Quarter Playbook

David Sterman

The stock market rarely moves in a straight line.

That's why many investors grew anxious in recent months as the S&P 500 managed to rise in 10 out of past 11 months. So it should come as little surprise that the market may be shifting gears as the second quarter gets underway.

The S&P 500 has fallen more than 1% on three separate occasions in the past two weeks, which has raised the specter of another spring sell-off. As I've written before, the market has suffered drops ranging between 9% and 17% in each of the past three springs.

But if we are headed for a similar downturn, then there's no reason you must sit idly by and watch your portfolio shrink. Here are several ways you can juice your returns, even in a down market.

1. Own volatility: One of the most remarkable byproducts of the recently rising market has been the dissipation of investor fear. Volatility, as measured by the VIX index, fell by half from June 2012 through the end of the first quarter of 2013.

But since bottoming out around 12 a week ago, the VIX is already back up to 16.5. For reference, the VIX surged to 45 in the spring of 2010 and again in the spring of 2011, though it peaked at 27 a year ago when the market was falling.

You can profit from a rise in the VIX through a range of exchange-traded funds (ETFs). I'm partial to the VelocityShares Daily 2x VIX ST ETN (TVIX). This is a "2X" fund, which means it moves twice as fast as the VIX. So a 50% jump in the VIX (from a recent 16.5 to around 25) would yield a 100% gain for this ETF. This is obviously a speculative investment and should be only a small part of your portfolio.

2. Watch the insiders and buybacks: If the market heads lower, then companies tend to step up their pace of buybacks; insiders tend to step up their purchases as well. Insiders tend to aggressively purchase company stock when their own company's outlook is more robust than a flagging share price would indicate.

Insiders are typically unable to buy shares ahead of a company's earnings release, but as we head into the heart of the earnings season, insider buying should pick up -- and you should be scanning the insider activity on a regular basis. I recommend InsiderInsights.com for its timely release of insider activity data.

3. Venture abroad: Even as our key market indexes remain close to their peaks, many emerging markets have reflected a more skittish mood in light of the still uncertain global economy. For example, the Market Vectors Vietnam ETF (VNM) has already given back its recent impressive gains.

And the iShares FTSE China 25 Index Fund (FXI) has slid 15% during the past three months, compared to a 5% gain for the S&P 500. Meanwhile, the Market Vectors Brazil Small-Cap ETF (BRF) has dropped 30% during the past two years, while the S&P has risen 20% in that time. That disconnect of 50 percentage points should spell opportunity for long-term investors.

In light of the uncertain U.S. market for the weeks and months ahead, it may be a bit premature to jump right into emerging-market funds, as they tend to slump badly when the U.S. and European markets pull back. Yet history has shown that these sharp pullbacks can create great entry points. So now is the time to start monitoring these markets and funds, as some of them may soon slump into deep-value territory.

4. Short Treasurys: Although the stock market is just beginning to show signs of weakness, the bond market has already sounded the alarms. The yield on 10-year Treasurys has steadily fallen by nearly 16% since mid-March.

The fall in yields typically signals a weakening economy. But a large number of economists still think the U.S. economy will perform much better in the second half of the year.

"S&P Economics is still projecting a 2.7% increase in real GDP for all of 2013, with growth above 4% in the second half and growth of 3.1% for all of 2014," said Sam Stovall, chief equity strategist at S&P Capital IQ. If he and other economists are correct, then the yield on 10-year Treasurys will move right back up above 2% or higher later this year.

That's why it may be profitable to invest in the ProShares UltraShort 20+ Year Treasury (TBT), which moves in the opposite direction of bond prices, at twice the pace.

Another option is the Direxion Daily 7-10 Yr Treasury Bear 3X Shrs (TYO), which moves at three times the rate of bond yields -- in the opposite direction.

Risks to Consider: As an upside risk, we have yet to reach the peak of the earnings season, and better-than-expected results could empower the bulls to return to their buying ways.

Action to Take --> The market gives and the market takes. Yet even in a market retrenchment, there are still plenty of ways to profit. Any of the ways I've mentioned in this article should be strongly considered as defensive mechanisms in this market.

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