Hedging Against Market Distribution

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Markets remain entrenched in a see-sawing battle between rising oil prices and improving corporate earnings. The problem is that one of these metrics (future oil prices) is forward looking while the other (past earnings) is the picture through the rear-view mirror. Rising oil prices most assuredly can derail our fragile recovery. Therefore, the duration and magnitude of the rise in oil will be a determining factor.

Meantime, we're starting to see some market-related troubles brewing on the horizon. Distribution days are starting to accumulate, putting pressure on professional investors. According to Investor's Business Daily, a distribution day occurs when an index closes lower than it did the previous day on heavier volume. This is an indicator of institutional selling.

The Nasdaq has racked up five distribution days in the past three weeks. Based on that, and the fact that we're seeing weak action from stocks that previously were market leaders, IBD concluded that the market is now in a correction. Wells Fargo's downgrade of chip stocks yesterday did not help the composite's performance either.

In a true market correction, investors should not be buying. In fact, if you are holding winners, it is important to focus on not giving back too much of your gains. Decide on a specific sell point for each position, and honor it.

Markets still have not indicated a clear sell signal. If the lows of two weeks ago are breached, that would be a sign that the correction has further to go. However, recent market action indicates that a bigger downtrend may be coming. Like the Boy Scout handbook states, it is always best to be prepared.

With oil now over $100 per barrel and gas prices fast approaching $4 per gallon, consumers and investors alike are taking notice. Recall that in October 2007 -- when oil reached $96 a barrel while on its way to hitting $150 per barrel the following summer -- the stock market topped out. In addition, the "Great Recession" also began in that same quarter.

One saving grace is that today's rise in oil prices is a supply issue, not a demand issue. This is why many observers, including Fed Chairman Ben Bernanke, are saying that these high oil prices will most likely be temporary (and therefore not debilitating). The problem is that no one knows how long or how much the supply will be disrupted. It doesn't look like the situation in Libya will wrap up anytime soon.

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