Track the companies that matter to you. It's FREE! Click one of these fan favorites to get started: Apple; Google; Ford.



Are You Prepared for a Market Correction?

Don't let it get away!

Keep track of the stocks that matter to you.

Help yourself with the Fool's FREE and easy new watchlist service today.

Don't let the August market doldrums lull you into complacency. The market will very likely get much more volatile before the end of the year. If you're not prepared, a spike in the level of volatility could lead you to take rash action, which rarely produces the best outcomes. Worse still, you could miss out on the opportunities that price action creates. Here are some ideas to prevent that from happening.

Volatility is coming -- it's in the numbers
First, why do I think that higher volatility is on the way? For evidence of that, one need only look at the prices of VIX futures expiring in September and beyond. The VIX index is a measure of the market's expectations for future volatility in the S&P 500, based on the stock index's option prices. High VIX values typically accompany market declines, with investors paying up for puts to hedge their stock holdings; thus, the VIX's nickname: Wall Street's "fear gauge."

On Friday, the index closed at 21.74 – the lowest value since the beginning of May, when the market started experiencing palpitations. By contrast, the October VIX futures contract closed at 29.15. For context, the VIX's average closing price during the months of May and June was 30.9 – you'll remember that was a challenging period for stocks.

What you shouldn't do
Don't go out and short the SPDR S&P 500 ETF (NYSE: SPY  ) on this basis. As far as I know, the VIX isn't reliable enough to enable you to time the market (what indicator is?). Furthermore, it's certainly conceivable that the market is overestimating the level of future volatility. Although I think this unlikely, as PIMCO Chief Investment Officer Mohamed El-Erian wrote last week: "With declining confidence in a reliable set of investing rules, markets have become more susceptible to overreactions to daily news and are, therefore, more volatile."

 Nevertheless, if you anticipate higher volatility, there are other ways to profit from market declines if you are looking at the right set of stocks beforehand. For example, if market prices do begin to swing wildly, we should expect high-beta stocks to be on the sharp end of that trend (beta is a standard measure of how volatile a stock has been relative to the overall market).

The best stock in a 'pariah' sector
The 15th-highest beta stock in the S&P 500, Masco (NYSE: MAS  ) , is more than twice as volatile as the S&P 500 (beta: 2.26). One of the world's largest manufacturers of branded products for home improvement and new home construction, it's one of the best names in an industry that has been run out of town by investors due to its dependency on the housing market. Although the shares currently change hands at 17 times estimated earnings for 2011, net income has significantly understated cash earnings over the past several years. If the market were to slip on a banana peel, it could provide a very attractive entry point to own Masco.

'High-beta' isn't the only strategy
Focusing in on high-beta stocks may be overthinking things. Megacap stocks tend to be relatively less volatile than the broad market, but you can't throw a dart at the list of Dow components without hitting a stock that is already attractively priced (well a couple of darts, at any rate). Take a look at these four:

  • Cisco Systems (Nasdaq: CSCO  ) -- forward P/E ratio: 14.1, debt/equity: 34.8%
  • ExxonMobil (NYSE: XOM  ) -- forward P/E ratio: 10.7, debt/equity: 8.4%
  • Procter & Gamble (NYSE: PG  ) -- forward P/E ratio: 15.2, debt/equity: 48.6%
  • Wal-Mart Stores (NYSE: WMT  ) -- forward P/E ratio: 12.9, debt/equity: 70.8%

High-quality: A good choice in the current environment
Any one of these stocks is a certificate of ownership for an armor-plated franchise, none of which carry a lot of debt. Both of which are attractive characteristics at a time when the economy is vacillating on the edge of deflation. Alternatively, if you aren't interested in selecting specific stocks, you could certainly do worse than to own the index, through the SPDR Dow Jones Industrial Average ETF (NYSE: DIA  ) .

Being ready for the next correction
In many ways, the current period marks the mirror image of the last stage of the technology bubble when high-quality, large-cap stocks traded at staggering multiples and were one of the most expensive segments of the market. Today, the same stocks are rather cheaper than the broad market – a rare phenomenon.

If your portfolio is heavy with low-quality, highly leveraged companies, you should be aware that those stocks are particularly vulnerable to a potential autumn market correction. Meanwhile, such a correction would provide an opportunity to buy shares in blue-chip, "franchise" stocks at even better prices than the ones on offer today. That's certainly a prospect worth being prepared for.

With the recovery stalling and the economy on the brink of deflation, dividends will become increasingly valuable. Jordan DiPietro has identified the best dividend stock. Period.

Fool contributor Alex Dumortier has no beneficial interest in any of the stocks mentioned in this article. Wal-Mart Stores is a Motley Fool Inside Value selection. Masco and Procter & Gamble are Motley Fool Income Investor recommendations. The Fool owns shares of and has written covered calls on Procter & Gamble. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.

Read/Post Comments (0) | Recommend This Article (20)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Compare Brokers

Fool Disclosure

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1263878, ~/Articles/ArticleHandler.aspx, 10/25/2016 5:05:47 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Today's Market

updated Moments ago Sponsored by:
DOW 18,169.27 -53.76 -0.30%
S&P 500 2,143.16 -8.17 -0.38%
NASD 5,283.40 -26.43 -0.50%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

10/25/2016 4:00 PM
CSCO $30.34 Down -0.12 -0.39%
Cisco Systems CAPS Rating: ****
DIA $181.48 Down -0.48 -0.26%
SPDR Dow Jones Ind… CAPS Rating: **
MAS $30.38 Down -3.18 -9.48%
Masco CAPS Rating: ***
PG $86.97 Up +2.87 +3.41%
Procter and Gamble CAPS Rating: ****
SPY $214.17 Down -0.72 -0.34%
S and P Depository… CAPS Rating: No stars
WMT $69.36 Up +0.17 +0.25%
Wal-Mart Stores CAPS Rating: ***
XOM $86.72 Down -0.19 -0.22%
ExxonMobil CAPS Rating: ****