An Easy Way to Protect Against Stock Losses This Year

Remember the No. 1 way to ensure stock market success?

Buy when others are fearful and sell when others are greedy.

Well, right now others are greedier than they’ve been since the stock market topped out in October 2007—just before the credit crunch and the big crash that followed.

Does that make me nervous? You bet!

The American Association of Individual Investors runs one widely followed survey. This measures the percentage of individual investors who are bullish, bearish and neutral on the stock market for the next six months.

According to the latest AAII survey figures, 52% of individual investors are bullish about stocks for the next six months.

That’s just shy of the 55% of AAII respondents that were bullish in October 2007. In the 12 months that followed, the S&P 500 fell 37%.

I’ll give you another example. In March 2000, investor bullishness reached 66%. A year after, stocks were down 25%.

You can see what I’m talking about from this chart. It shows that bearish sentiment hit a record low of 6% in August 1987—just before the S&P 500 lost 23.4%.

Here’s the problem…and why I’m always wary when individual investor sentiment reaches these kinds of highs. By the time the market convinces investors that it’s a good time to invest most of the good news is already priced in.

Over the long term, big trends and value considerations are what matter. But over the short term, sentiment is critical because it is a major determining factor for short-term stock prices.

But over the short term sentiment is the market. That’s because for 99.9% of investors, emotions drive their investment decisions. When sentiment changes, so does the short-term direction of stocks.

There’s another very easy way to see how the market is “feeling”—the CBOE Market Volatility Index, or VIX.

By calculating the prices of a range of options on the S&P 500, the VIX measures the market’s expectations of stock market volatility over the next 30 days.

When the VIX is above 30, we know that there is a relatively large amount of fear and uncertainty among investors. And when the VIX is below 20, there is a relatively low level of fear and high level of complacency among investors.

Right now, investors are even more complacent than they were before the 2008 stock market crash. Same goes for the so-called “flash crash” last May, which saw the biggest one-day point decline on the Dow.

How to Protect Your Portfolio From Another Sudden Crash

This chart is sending a clear warning to investors. Problem is, most of them don’t want to hear it. Instead, they’re busy trying to make back their losses by plowing money into a stock market that has already seen a big run-up in prices.

I’m not saying sell all your stocks now. It’s true that the market can stay irrational for a long time. And this time is probably no different.

But if I were you, I’d consider taking out some “insurance.”

One simple way of doing this is to by the iPath S&P 500 VIX Short-Term Futures ETN (NYSE:VXX). This exchange-traded note rises as the VIX rises, giving you a measure of protection should fear levels spike again.

Because VXX is a futures-based product, it doesn’t always track the VIX perfectly. But the correlation is pretty strong.

Consider holding about 2% of your portfolio in VXX. This will provide you with a decent hedge should extreme levels of bullish sentiment prove yet again to be a contrarian indicator.