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ETF Periscope: The Eurozone Tests Its Firewall

 June 11, 2012 12:09 PM


"Politics is the art of looking for trouble, finding it everywhere, diagnosing it incorrectly, and applying the wrong remedies."  — Groucho Marx

The latest news out of the Eurozone is that a bailout of Spanish banks is due to occur shortly. No doubt Wall Street will celebrate at the thought that the PIIGS (Portugal, Ireland, Italy, Greece and Spain) may all yet survive and the Eurozone shall remain intact.

The problem is that this particular bailout, like the ones that have preceded it, tends to address the problem of bank liquidity rather than the deeper issue of sovereign debt. The debt crisis requires a way for the Eurozone to share debt, such as the Eurobond concept. Without addressing that issue, the can will keep getting kicked down the street until it hits a cul-de-sac. That moment will come suddenly, and probably sooner than later.

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This cycle of equity-buying euphoria will probably be as short lived as the one that followed the last round of announcements that Greece would receive further bailout funds from the European Union (EU) and the International Monetary Fund (IMF). The scorecard to watch closely is the yield of Spain's 10-year bonds, which were hovering above the 6% mark as of last week. How far they dip in response to the current bailout won't be the main thing to watch for, however. What to keep close tabs on is just how fast they ratchet back up.

There will be a certain tipping point where the risk simply won't warrant a mere 6% yield. And, if and when it rises back to the 7% mark, there may not be enough bailout funds readily available to contain the next phase of what may be viewed as the latest contamination resulting from the threat of one or more of a PIIGS default. The question is how orderly that default unfolds.

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What the Periscope Sees

In spite of the likely euphoria that hits the market in response to yet another Eurozone bailout, this one for Spain, there remain a number of issues that the bailout fails to address. The bottom line is that the debt crisis in Europe remains in place, and therefore subject to high levels of volatility. Coupled with the situations in Iran and Syria, investors should remain wary and maintain a posture of portfolio defense.

A broad way to hedge against the volatility in the market is with a volatility vehicle. The one that many investors are familiar with is the VIX, commonly referred to as the "fear gauge." The VIX serves as a handy way to keep score of the balance between option puts and calls, which in turn provides a sense of which way investors feel the way the market winds are blowing. Though you can't trade the VIX directly, there are a number of derivatives that may be used.

The VXX (S&P 500 VIX Short-Term Futures ETN) tracks the S&P 500 VIX Short-Term Futures Index, and serves as a proxy for investors and traders who don't want to trade VIX futures contracts. While one should not expect it to mirror the VIX precisely, as there are a number of other factors to consider in the ETN's mix, there is enough of a correlation to help retain its effectiveness as a hedge. If you are sitting on a portfolio weighted to the Bullish side, perhaps having taken advantage of recent "bargains" as the equity market has corrected in recent months, you might consider using the VXX as a broad hedge to rebalance your positions against possible sharp declines. Remember, however, that the VXX, like the VIX, generally goes up as the equity market goes down, and vice versa. So position your hedge accordingly.

Another hedge to consider may be a less obvious one.

With oil having experienced a huge correction over the last several months, coupled with its tendency to experience big moves in a number of geopolitical circumstances, this may be a good moment to consider using oil as a hedge as well, as it may have more room to move up fast in the near term than it does to fall in the same time period.

How might an oil hedge work? You could utilize an ETF such as USO (United States Oil Fund), which tracks the change in price of light sweet crude. By going long USO, which would move up sharply if events in the Middle East heated up, you have a specific-circumstance type of insurance trade in place. It can be considered as one weapon in an arsenal of hedge-related ammo.

ETF Periscope

Full disclosure:  The author does not personally hold any of the ETFs mentioned in this week's "What the Periscope Sees."

Disclaimer: This newsletter is published solely for informational purposes and is not to be construed as advice or a recommendation to specific individuals. Individuals should take into account their personal financial circumstances in acting on any rankings or stock selections provided by Sabrient.

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