I feel like I am walking on a high wire.

The markets are continuing their ascent from the October lows where I went 100% long, and the technical indicators seem to be improving by the day with 77% of S&P 500 companies trading above their 200 day moving average. Earnings continue to beat the Street’s expectations and the GDP numbers continue to be positive.

What’s not to like about this?

Percent of stocks in the S&P 500 above the 200 day moving average

What could possibly go wrong?

Earnings and the 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 which make up the markets going to be able to maintain their strong earnings amidst a slowing global economy? China and Europe’s economies are both slowing down. Will the US soon lead the world into stronger growth, follow, or be dragged down by these other countries’ economic contractions?

The fear index

The VIX index just crossed south of 20 as shown in the graph below. This index measures the amount of fear investors have and the lower the number the more complacency investors have. Also supporting this theory, the AAII (American Association of Individual Investors) Investment Sentiment Survey for the week ending 1/25/2012 shows bullishness is at 48.4% and bearish investor sentiment is at 18.9%.

Remember, it was just last year when we were having 3-5% weekly – sometimes daily – gut wrenching markets swings. Is this time period a pause in the volatility or are we on the edge of the abyss?

Fear Index

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 as well. You can use options, which I do not, or utilize inverse market ETF’s (Exchange Traded Funds) such as an SH or SDS, both which inversely track the S&P 500 Index and increase in value when the S&P declines. SH is a Short ProShares ETF that seeks a return that is 1x the return of the S&P 500 and SDS more aggressively seeks a 2x the return of the benchmark. Now is the time to learn how these and other ETF’s work and what advantage they could be for you.

The fact that most investors are complacent, relaxed, and kicking back does not mean that you cannot be using 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 on to it during market declines. Don’t get stuck on the high wire when the bottom falls out.

To learn more about ETF’s go to http://etf.about.com/

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Billy and Akaisha Kaderli are recognized retirement experts and internationally published authors on topics of finance and world travel. With the wealth of information they share on their popular website RetireEarlyLifestyle.com, they have been helping people achieve their own retirement dreams since 1991. You can order their latest book, Your Retirement Dream IS Possible here.

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