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I feel like I am walking on a high wire.
On one hand, the markets have continued to rise sharply from their October lows when I went 100% long. Earnings continue to beat the Street's expectations and GDP numbers continue to be positive. Moreover, the vast majority of individual stocks have participated in the rally, with more than three-quarters of all S&P 500 companies trading above their 200-day moving averages.
Percent of stocks in the S&P 500 above their 200-day moving average
What's not to like about this?
Stop looking backward
The problem is that earnings and last quarter's GDP numbers are so yesterday. What happened last quarter, last week, or even yesterday is not where investors are looking. They want to know the future. Are the companies that make up the markets going to be able to maintain their strong earnings amid a slowing global economy? China's and Europe's economies are both slowing down. Will the U.S. soon lead the world into stronger growth, follow, or be dragged down by these other countries' economic contractions?
The fear index
Investors seem not to think so. The VIX, which some call the "fear index," has fallen sharply over the past several months. This index measures the amount of fear investors have, and the lower the number, the more complacent investors are about the market.
Also supporting this theory, the American Association of Individual Investors' Investment Sentiment Survey for the week ending Jan. 25 showed bullishness at a whopping 48.4%, while bearish investor sentiment was just 18.9%.
Remember, it was just months ago we were having gut-wrenching swings of 3% to 5% weekly -- and sometimes daily -- in the stock market. Is this time period a pause in the volatility or are we on the edge of the abyss?
Run for the hills?
In my opinion, it is a little early to make extreme moves like selling everything and running for the hills based on the above. However, if the markets do start moving lower, will you be prepared? Now is the time to have a plan in place to protect your capital.
A hedge is not just something that grows in your yard
Hedges can be used to protect your long positions. You can use options, but I've found that inverse market ETFs fit better with my risk profile. ProShares Short S&P 500 (NYSE: SH ) seeks a daily return that's the opposite of the S&P's return -- so if the index falls 1%, the ETF should rise 1%. ProShares UltraShort S&P 500 (NYSE: SDS ) goes even further, seeking double short exposure to the S&P 500.
These ETFs come with pitfalls, especially if you plan to use them over the long haul. But if you're concerned about preserving your capital, now is the time to learn how these and other ETFs work and what advantages they could give you.
The fact that most investors are complacent, relaxed, and kicking back does not mean that you should be. Use this time to educate yourself and prepare for the next down cycle, which is sure to come.
I hope that I am wrong and the markets continue to climb in 2012, but hope is not a strategy that I am willing to use. Preservation of capital is a must during these unique times and it is imperative that you have a plan to hold onto it during market declines. Don't get stuck on the high wire when the bottom falls out.
Being aware of risk is smart, but the right long-term investments are less risky than staying out of the market entirely. If you want to retire rich, read The Motley Fool's latest special report, which reveals the names of several promising stocks that have what you need. It doesn't cost a dime -- but grab it today while it's still available.