Are You Prepared For a Market Drop?

The stock market has experienced the perfect storm of bullishness in 2013.

The Dow Jones Industrial Average is making new all-time highs, surging more than 9% within the first three months of the year. Meanwhile, the broad market barometer known as the SP 500 has pushed within 20 points of the all-time high of 1,565 reached back on Oct. 9, 2007.

The market rally is being fueled by an ideal combination of the Federal Reserve's quantitative easing measures mixed with improved housing numbers and employment data.

However, no matter how bullish things appear, markets never rise in a straight line. There are always pullbacks, negative news and other bumps in the road.

Knowing this fact, the question is, are you prepared for the inevitable pullback?

While no one knows for certain when the rally will falter, there are definitive signs of a short-term top starting to develop.

First, there is the seasonality issue. As I said before, the "March effect" may present another market sell-off.

In addition, interest rates are slowly starting to tick higher in the bond market. Recently, the price of the 10-year Treasury note fell 16/32 to 100 2/32, and its yield climbed to 2%. And as noted pundit Nouriel Roubini says, President Barack Obama's tax increases are going to severely affect spending in the second half of the year, resulting in a steep stock market decline.

Finally, the CBOE Volatility Index (VIX) is below its long-term support on the weekly chart, as you can see below. Also known as the "fear index," the VIX measures the expected volatility in the market based on SP 500 option contracts. The VIX moves inversely with the stock market. In other words, when stocks go up, the VIX index drops and vice-versa. With the VIX trading below its technical support of the past three years, an upward move seems overdue. This move will correspond with a drop in the equity markets.

Fortunately, there are ways to prepare your investment portfolio for the inevitable decline while maintaining exposure to the stock market.

One way is by switching your stock holdings into low-beta, which measures the volatility of a stock. The lower the stock's beta, the lower the risk compared to the broader market. Consumer staples and utilities are considered low-beta investments.

As soon as the public catches on that the bull run has faltered, there will be a race to the safety of these types of investments, pushing them even higher. They provide safety as well as growth potential.

However, I like the convenience, built-in diversification and professional design of exchange-traded funds (ETFs) better.

Here are two ETFs to help you get started building a low-beta portfolio to help weather and even profit from the pending stock market drop.

1. SPDR SP Pharmaceuticals ETF
SPDR SP Pharmaceuticals ETF (NYSE: XPH) is a pharmaceutical-based exchange-traded fund that has a beta of 0.82 against the SP 500 index, which has a beta of 1. This beta is higher than what you might consider a low-beta ETF, but let me explain why.

The fund has solid returns with more than 9% year-to-date and nearly 18% during the past three years. While blue-chip pharmaceuticals such as Eli Lilly (NYSE: LLY), Pfizer (NYSE: PFE), and Merck (NYSE: MRK) all have very low betas, this ETF has only 17% exposure to these big-name pharmaceuticals.

Its designers combined the solid-value firms with edgier growth-oriented stocks such as Salix (Nasdaq: SLXP) and Questcor (Nasdaq: QCOR). The clever mixture has provided a beta less than the SP 500, while allowing for impressive appreciation.

 

2. Guggenheim Frontier Markets ETF
I was surprised to see Guggenheim Frontier Markets ETF (NYSE: FRN) on my list of low-beta, low-relative volatility ETFs. I immediately thought it must be a mistake. After all, frontier markets such as Kuwait, Nigeria and Kenya are very volatile, right?

Well, the surprising truth is that frontier markets have shown much less volatility than the MSCI Emerging Markets Index and even the SP 500 during the financial crisis of 2008 and today. Boasting a beta of just 0.75, this ETF appears to be a solid place to ride out any U.S. stock market storm while taking advantage of global growth in under-the-radar markets.

Risks to Consider: The stock market has inherent risk. No one knows the future and anything can happen. However, a well-diversified portfolio including unexpected low-beta, stocks has been proven to build wealth over time.

Action to take -- XPH and FRN are wise investments for those building a portfolio that will weather any market storm. XPH is a mass sense as a momentum play with lower beta than the broad market. It is obviously correlated to the U.S. markets, so it will benefit should the bull market continue, yet provide a margin of safety due to its lower beta. FRN should be used as a choice for those seeking safety away from the likely pending dip in the U.S. markets.

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David Goodboy