I keep track of indicators that often signal warnings before market crashes. In reviewing the current market, there are a number of sectors that seem to be in danger of a collapse. But most worrisome, is that two sectors that are considered ultra-safe look set to crash.
The first sector is a traditional conservative investment: municipal bonds. Mutual fund investors have been flooding the municipal bond market with cash. Bloomberg reported that buyers have outnumbered sellers of muni bond funds for 18 straight weeks, investing $964 million in late August. Some of the buying is probably driven by the approach of the "fiscal cliff" at the end of the year, which would raise income taxes and make tax-free income more appealing. This is a $3.7 trillion market where many issues are insured against default, but I show more than 20 different closed end municipal bond funds giving a crash signal right now.
These signals show up on the weekly charts, and were all given before we learned that Warren Buffett turned bearish on munis. Buffett's Berkshire Hathaway cancelled more than $8 billion worth of derivative contracts that insured buyers against muni defaults. That news indicates that Buffett looks at munis as a risky trade right now with defaults likely to become a concern, and the relative strength index (RSI) confirms that.
The crash signal that so many municipal bonds are showing this week occurs when RSI breaks below the lower Bollinger Band drawn on the indicator. RSI is a momentum indicator and technical analysts believe that momentum moves ahead of the price. Bollinger Bands can be added to the indicator, which show when momentum is moving very quickly. If downside momentum accelerates sharply, RSI will break below the lower band and prices tend follow the indicator lower.
By design, these signals are rare and should only be seen about 3% of the time. When they cluster in one sector it shows that something very unusual and bearish is going on in that sector.
Funds with bonds issued by California, New Jersey, New York, Maryland, Michigan and Ohio have all given a sell signal this week. These funds are thinly traded and could be difficult to short. For traders looking at profiting from a decline in this market, iShares S&P National AMT-Free Municipal Bond (NYSE: MUB) is a possible short, although there is only a small potential gain.
MUB has not given a sell signal yet, but with so many closed end funds signaling a sell it is very likely we'll see declines in this ETF as well. The first profit objective, based on the small trading range that has formed since June, is about 2.8% below the current price.
The second "safe" sector that looks ready to crash is inflation protected bonds. Falling bond prices could easily wipe out several years worth of income from these bonds. That means even conservative investors should consider selling bonds and bond funds now and buying them back later.
iShares Barclays TIPS Bond Fund (NYSE: TIP) hold inflation-protected Treasury bonds. After moving steadily higher over most of the past year, prices fell sharply last week and that decline could continue. The chart below shows that RSI has broken below the lower Bollinger Band.
The first resistance level for TIP is near $111, about 6% below the recent price. More significant resistance sits around $103, almost 13% below the recent price. In bear markets, inflation-protected securities can decline sharply. TIP fell 25% in 7 months in 2008.
Traders should consider buying ProShares UltraShort TIPs (NYSE: TPS) to profit from a decline in this sector. TPS is leveraged and is designed to move opposite to the direction of TIPs and deliver twice the daily price move on a percentage basis. If TIPs fall 1%, TPS should gain 2%.
This ETF is thinly traded with an average volume of about 7,000 shares a day. When trading ETFs with low volume, you should consider using a limit order. One way to get a fair price on the trade is to enter a limit order halfway between the bid price and the ask price. Before doing that, it might be best to try placing a buy order at the bid price. TPS was recently trading with a spread of 10 cents, so a limit order will save traders up to about 1% in trading costs.
With municipal bonds and Treasuries giving a crash warning, traders should consider exiting any fixed income investments for now.
Action to Take --> I recommend buying shares of TPS at a limit price of $27.30. Be sure to set a mental stop at $26. TPS is thinly traded and a stop that is entered ahead of time is likely to be triggered. It is best to plan to sell with a limit order the next day if TPS closes under $26. Set the initial price target at $32.
This article originally appeared on TradingAuthority.com: