Choppy waters ahead – batten down the hatches and short the market

We face a summer exciting in possibilities and daunting in turbulence. Here's how to prepare for it.

I'm wary of trying to second-guess the direction of financial markets. My market timing record is utterly dreadful and I'm not alone endless academic studies have shown that even the so-called market professionals get their key "big picture" market calls wrong more often than not.

But with that caveat in mind, I have to admit that I am growing more nervous about markets as we head into spring and summer. Maybe I'm just being subconsciously influenced by the old investing rule that you should sell in May and come back in September/October.

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But I also think we could see increased market turbulence in the short term, due to a cluster of potential problems on the horizon. So here I'd like to explain each of these threats in turn, and suggest some investment ideas that might help mitigate against this turbulence.

But just to be clear, before I get all bearish on you, my concern is purely in the short term. While I think we're entering a turbulent period, with key numbers suggesting a slowdown in the global economy, I also reckon we're a long way away from anything as drastic as full-blown recession.

So this is a piece for those who are looking to make a quick profit from potential near-term turbulence. If, instead, you're a long-term investor who simply sees market volatility as a good opportunity to keep investing in quality equities at lower prices, then this article is one you can ignore in favour of building your retirement pot.

A cluster of potential nasties

So with that out of the way what'sgot me worried? My hunch is thatwe are in an economic soft patch,where market turbulence could growas investors fret about a global slow-down. The best summary of this cautious world view comes in an excellent warning from risk-consulting firm CheckRisk, which is run by former hedge-fund manager Nick Bullman.

A few weeks back, Bullman told his clients that a whole series of measures indicate "elevated levels of risk in financial markets at a time when the global economy appears to be slowing". Reasons for caution cited by CheckRisk include:

1. A growing risk of "non-weather related consumer spending in the US" falling.

2. The threat of a poor earnings season in the US and elsewhere.

3. The risk that the Chinese economy slows to 4.5% or 5% GDP growth, versus reported numbers of 7%.

4. A general increase in geopolitical risk levels.

5. Ongoing commodity price deflation.

6. The expensive valuations seen in both equities and bonds, leaving markets vulnerable.

7. The lack of "real" (after-inflation) yields on offer in markets.

8. The "illusion of liquidity" in bond markets in other words, investors are happy to pile in, but they're not thinking about what might happen if they all try to get out at the same time.

With that lot going on, I agree with Nick that now may be the time to take some profits and maybe even consider a spot of hedging. And I'd add a few risk factors of my own.

What I'm worried aboutThe UK election could be about to usher in a period of great uncertainty. I'm particularly worried about the risk of constitutional turmoil but foreign investors will probably focus more on the deterioration in our current account, and the huge structural government deficit.

Paul Jackson, at exchange-traded product provider Source, notes that in some ways, Britain looks "more and more like the sort of badly managed and imbalanced economies" we'd associate with the worst sorts of banana republics. So while the Bank of England may be considering raising interest rates, "short-term uncertainties and long-term disequilibria suggest sterling may have to go lower".

On top of that, the UK blue-chip equity market is nowhere near as cheap as it might look. One note in particular, from analysts at Societe Generale, struck me last week. The research team argued that, despite appearances, UK shares are actually quite expensive, given that earnings look set to fall due to a mix of the strong dollar, the strong pound and an excessive focus on the resources sector.Outside the UK, Greece is a worry. I'm concerned that "Grexit" is on the way.

I can't see how the Greek government will be able to repay its bill of nearly €2.5bn by 20 June. Sure, if a deal was struck on economic restructuring and a mutually agreeable vision for the future, these payments could easily be rolled over but the mood music from the ongoing talks doesn't sound promising.

And speaking of dates for the diary, there's the June meeting of oil cartel Opec, where I'm convinced the Saudis will try to talk down the price of oil yet again. This will coincide with a final push to derail any deal with the Iranians over nuclear weapons after all, think of the damage that oil at $20 a barrel would do to the Iranian economy, regardless of what happens with sanctions.

Finally, we might even see a term that's barely been discussed by financial or economic commentators in recent months making its way back onto the agenda inflation. David Absolon at Heartwood Investment Management has suggested that we could "start to see disinflationary forces unwind", and central banks judging by their comments generally agree with him. While the eurozone remains in deflation, "a consensus is starting to build that we may have seen a trough in prices", notes Absolon.

So I reckon the summer will be exciting in its possibilities and daunting in its turbulence. I'm currently running my portfolios at 40% cash and actively taking profits where I can.

The best ways to short the market

But how about being much more pro-active and using funds or exchange-traded products (ETPs) to hedge the risk of a drop in the UK market? I'd suggest planning for a 10%-15% correction. But I'd also point out that some of this turbulence might be very specific to the UK and Europe. So it would be a mistake to bet on an increase in market volatility by tracking an index such as the US Vix index (which goes up and down based on the S&P 500's direction) because you'd be betting on the wrong index, in the wrong country.

Traditionally, the best hedge for mainstream British investors has been to switch into ultra-safe UK government bonds, but I'm not sure that's a great idea either. Gilts could be a victim of a post-election sell off by foreign investors who worry about political instability although to be fair, that risk would be very low if you were invested in short-duration bonds, which are yielding next to nothing.

I'd also be wary of investing in another traditional investment backstop gold. Some of the dangers I cite above are specific to certain regions or countries, and the general concern about deflation hasn't entirely lifted from the markets which might help to undermine confidence in the shiny stuff (which is usually seen as more of an inflation hedge).

So all in all, I'd stick with a short-term bet against the FTSE 100 index with the idea of it perhaps falling by as much as 12.5% from its current level, to around 6,180. One adventurous option could be to target an index called the VFSTE, which tracks turbulence in the FTSE 100 (a bit like the Vix does for the S&P 500), but outside of spread betting, I'm not aware of any mainstream product that lets you access this market as a retail investor.

This leaves the opportunistic among us with two main options daily-leveraged trackers from Boost ETP and ETF Securities, and a relatively new derivatives-based product from Societe Generale called "infinite turbos" (SG also has its own daily leveraged trackers).

A three times "short" daily tracker would maximise any returns from a fall in the FTSE 100, but investors need to move with some care with the two main products in this market ETF Securities 3x Daily Long FTSE 100 (LSE: UK3S) and Boost's FTSE 100 3x Short Daily ETP (LSE: 3UKS). Daily trackers give you the best results if markets "trend" consistently one way or another, ie, if you are in a short tracker, you want to see the market march lower day after day.

Daily leveraged trackers are more problematic if markets are very volatile, if, for example, the FTSE 100 shoot downs 7.5% one day, then up 2.5% the next, before falling another say 4% and so on. These products do what they say on their product label they are daily leveraged trackers, best used in a trading period of days, not weeks or months. Still if markets do trend lower, these could be a very useful way of hedging downside exposure.

An alternative for an investor looking at the next eight weeks is an "infinite turbo". These are like good old-fashioned derivative-based covered warrants, except that you don't have to worry so much about the "time decay" built into the products. This sounds like a complicated idea (and in the maths that lurk behind these products, can be) but in reality it reflects a simple notion that over time, the value of an option insuring against an outcome decays in value.

Infinite turbos are essentially open-ended and allow you to make a bet on the direction of a financial asset without worrying whether that move will happen next week, next month or at the end of June. The key concept is "leverage" or "gearing", which describes how many times the product will rise in value against the reference index.

To take one example, the SG turbo called MF04 has a gearing of 23 times the FTSE 100, on a short basis. This means that, all things being equal, every 1% fall in the FTSE 100 will see this product's value increase 23-fold. So my 12.5% putative decline would result in a near 400% gain in the total price of the security.

However, be aware that this product also features a "knock out" which means it'll expire worthless if the FTSE 100 pushes above 7,273 over the next few months. In my own case, with net exposure to equities running at 50% of my portfolio, I'd only need to invest 1.5% of my total assets to completely insure my portfolio against a market fall of 12.5%.