The S&P 500 Index has been up nearly 92% since March 6, 2009. This impressive run has many market participants cheering for the rally to continue indefinitely. But as exciting as it may be to reference that 92% return, it is not very important, except for investors who bought into the market on March 6, 2009. Most investors were invested in the market before that day and many had ridden the entire wave down from the October 2007 highs. To date, these investors have recovered a significant portion of their losses, but are still far from whole.

Optimism regarding the global economic recovery has waned recently, as statistics in a variety of areas have worsened, helping to push stock markets lower. Unemployment has increased to 9.1%. Housing data is consistently bad, as the inventory of unsold homes and pending foreclosures fails to diminish. Home prices in some parts of the country are back to levels last seen in the year 2000, causing many Americans to feel less wealthy overall.

The Federal Reserve has stated it will let “QE2,” the practice of buying U.S. Treasury bonds to add liquidity to the money supply and credit markets, end in June and has no plans for QE3. QE1 and QE2 have been critically important in helping the economy recover. Meanwhile China’s economy, one of the key drivers in the global economic recovery and the second largest economy in the world, has been slowing down. We are quite dependant on China, not just as a trading partner, but also as a lender, through their purchases of U.S. Treasury bonds. Simply put, China’s money has helped fuel our recovery.

We can hold on to optimism, but the pragmatic view is that we may have already seen the peak in this economic recovery and in the stock market. The S&P 500 topped most recently on April 29, 2010 with a high close of 1,363.61 and has pulled back 3.7% since then to the June 6, 2011 close of 1,286.17. This brings the index back to levels first attained in January and February, conceding much of the year-to-date gains.

Without a catalyst to improve the economy and send markets higher, it is prudent for investors to position for a correction, and a potentially sustained one at that. Market participants are not gun-shy these days, so additional poor economic data could send more money to the sidelines to sit out a sell-off and wait for measurable improvements in the economy.

Does this mean you should sell your stock market holdings? Maybe, but not necessarily… What this does mean is you need to protect your gains and preserve capital in case a more protracted retracement does occur.

Consider these three exchange-traded funds (ETFs):
   
1. iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX) 
This exchange-traded note (ETN) seeks to replicate the performance of the S&P 500 VIX Short-Term Futures Total Return Index. The VIX is a commonly referred-to measure of volatility for the S&P 500. When the VIX is moving higher, implying greater volatility, the S&P 500 generally moves lower.

As illustrated in the chart below, this ETN is almost perfectly negatively correlated with the S&P 500. If bought by itself, this is a very pure contrarian play. If you invest in VXX while also holding the SPDR S&P 500 (NYSE: SPY), then you have a very good hedge.


 
2. ProShares Short QQQ (NYSE: PSQ) 
This fund invests in derivatives and seeks the inverse of the performance of NASDAQ 100 Index. Here again, we have an example of nearly 100% negative correlation to the index. The opposite of this ETF is the PowerShares QQQ (NYSE: QQQ). So if you are tech-heavy or simply hold QQQ, then taking a position in PSQ would create another very strong hedge. Holding PSQ alone would make a strong bearish statement regarding where you think the Nasdaq is headed.

 


3. ProShares UltraShort S&P500 (NYSE: SDS)
This ETF seeks results which correspond to two times the inverse of the daily performance of the S&P 500. That means if the index is down 2% on the day, then SDS should be up about 4% on the day, and vice versa.

This fund is not for the faint of heart. The chart below shows a high level of correlation, but since SDS is targeting two times the inverse performance of the S&P 500, this ETF is very volatile and risky. An investor in this ETF would need a high risk tolerance and very strong convictions regarding the direction of the market. If you’re right, the upside is tremendous.

Action to take –> Don’t get caught sitting on your hands. The first rule of investing is “don’t lose money.” Utilize these funds as a hedge against long positions in your portfolio. But if you’re very confident and have high a risk tolerance, invest in these funds without a hedge and make a distinct contrarian call against the markets. The payoff could be well worth it.

P.S. — If you’re an income investor, why would you buy a stock yielding 2% when you can find one paying 26% right here? Watch this presentation for more.