VXF - The Fed Moment: Don't Forget To Hedge

• The Fed's decision is imminent this Wednesday.
• While the market is pricing in a 75 basis point rate increase, it may get shocked if the Fed raises by a whole 1%.
• The S&P 500 is around a critical technical level, and the current rally will probably get cut short if the Fed raises by 100 basis points.
• Moreover, the stock market could cascade through critical support levels, leading to new lows before the bear market ends.
• It's a crucial time to hedge, and I'm implementing my six-step hedging plan here.

Finally, it's Fed week. The FOMC's decision on interest rates will be out on Wednesday, and the market expects another 75 basis point hike this week . With inflation raging at multi-decade highs (9.1% CPI), the Fed must act decisively to cool prices, as the inflation situation threatens to get out of control. Continuous high inflation will lead to worsening consumer spending and sentiment. Moreover, higher production and labor costs will further pressure corporate margins, leading to lower profits and negative adjustments to the bottom line. However, as the Fed raises interest rates, the cost of borrowing increases, and the economy decelerates. Therefore, the Federal Reserve has the challenging task of bringing down inflation without slowing the economy too much.

Can the Fed succeed in handling the challenge? Regardless of the answer, it has to try. Also, it depends on your definition of what success is in this case. We see that the stock market is already in a bear market. The S&P 500/SPX ( SP500 ) has declined by approximately 25% from peak to through. The Nasdaq and certain other stock indexes are down by 30% or more in the same time frame. So, the $64,000 question is, have we seen the bottom, or will we see more downside ahead? Another question is how much more downside could we see, and in which sectors? Also, will the stock market begin faltering now, soon after the Fed meeting, or down the line at some point? Well, the short answer is - it depends. Nevertheless, here are my views on the economy, the upcoming Fed meeting, and how stocks could react as we advance.

The S&P 500 3-Year Chart

The bear market started at the beginning of the year. So, the general market's decline has been ongoing for some time now, roughly 6-7 months. However, the Nasdaq, tech, and growth names began crashing before the S&P started to decline. The Nasdaq composite dropped by 35% from peak to trough, and many individual stocks cratered by 50% or more during the selloff.

Given the length and scope of the declines, we're very likely in the later stages of this bear market. Moreover, we're probably much closer to the end than the start of the decline. However, more downside is plausible, and a great deal depends on the Fed.

Strictly from a technical standpoint, if the 3,650-3,600 support level doesn't hold up, the SPX should drop to the 3,400 support level next and may decline to the 3,000 in a bearish case outcome. The bear market decline has been approximately 25% for now. At 3,400, the fall will be 30%, and at 3,000, it will be around 38%. Therefore, we want to avoid any further downside from here.

The Fed's Inflection Moment

While 75 basis points may be priced into the market, a whole percentage point is probably not.

There's about a 76% probability that the Fed will lift the benchmark rate by 75 basis points to 2.25-2.50% at the upcoming Fed event. Last month's hike also was 75 basis points, and the market seems ready for the move. However, there's about a 24% chance that Wednesday's rate increase will be 100 basis points. Such an aggressive rate increase will likely shock markets and will suggest that the Fed is significantly more hawkish than the market expects now. Therefore, this disconnect between the market's expectations and the Fed's policy path could result in further weakness for stocks.

Stocks at a Critical Level

S&P 500 1-Year Chart

The SPX has rebounded by approximately 10% from the bottom and is at a critical resistance point around 4,000 now. If the Fed raises the benchmark rate by 75 basis points and comes out with a relatively dovish statement, we will probably see a continuation of the rally through 4,000 and beyond. However, if the Fed raises the benchmark by 100 basis points or comes out with an overly hawkish tone, we will likely witness an abrupt end to the rally.

Moreover, if the Fed is more hawkish than the market perceives, the SPX could crash through support soon, and new bear market lows could materialize quickly. Therefore, there's a lot on the line, the Fed knows it, and the FOMC needs to walk a fine line during the Fed event to reassure markets that it is containing inflation without creating market turmoil at the same time.

My Six-Step Hedging Plan

It's typically good practice to hedge during times of volatility or increased uncertainty, especially around critical technical levels in a bear market and around an FOMC event. Therefore, I'm implementing my six-step hedging plan.

Step One - I'm staying diversified. You never want to have all of your eggs in one basket or own a single group of stocks from the same sector. Therefore, I've split up my stock investments into several sectors that should outperform. Moreover, I've picked the top names likeliest to exceed the results of their peers in their respective sectors.

Step Two - I began selling/writing some call options against some of my stock positions to increase yield and add a layer of protection in case some stock fall. Due to the current uncertain environment, many stocks offer substantial premiums of 5%-10% or more (4-6 week period) if you sell call options against the shares you own.

Step Three - I'm considering hedging riskier positions for potential downside ahead with puts and collar options. As the Fed meeting approaches, I will monitor price action carefully. If the market starts heading south, I will layer a put on top of my covered call options or buy puts to hedge specific positions instead.

Step Four - I'm setting up hedging and stop-out triggers around critical technical levels (below/around SPX 3,900-3,850 and 3,750-3,640). If SPX and specific stocks fall below essential points of support, some of the positions will be stopped out, while others get hedged via put or collar options strategy.

Step Five - Additional rotation. If price actions worsen, I will rotate more capital towards defensive sectors (i.e., staples, healthcare, defense, and others).

Step Six - Step six is simple. If there's a significant post-Fed breakdown, I will raise my portfolio's cash reserves and will build my dry powder position to deploy at lower levels.

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