The “black swans”…

And the Japanese earthquake definitely classifies as a black swan.

Not only did a 9.0 earthquake decimate them, but they also felt the destruction of a devastating tsunami… and now a potential nuclear meltdown.

To be sure, these kinds of big, game-changing events don’t happen very often. But when they do, we must stay nimble and open to any changes.

Thankfully, we’d already taken all the precautions we needed…

 We reduced our “long” exposure in the Strategic Investment portfolio. Our interest over the last few weeks has been in capturing some winners… and getting rid of any weaker positions we held. Thanks to these precautionary moves, our closed positions are up over 30%.

 We are short the Chinese stock market. As Japan sees its GDP slow as a result of this catastrophe, growth in China will slow too.

 We are short the S&P 500. After the technical break we saw last week, it was imperative to hold a hedge. In just a few days, this hedge has already paid off with a 60% return.

So, What Next?

Simple: over the next week, we’ll stay focused on what effect this Japan catastrophe will have on the broader global markets.

The big news out of the country is the potential Nuclear Meltdown. While the world may not be staring straight into the horrors of another Chernobyl (which spewed heavy nuclear waste into the atmosphere after a full nuclear meltdown), there is serious risk of radiation spreading across the country. And the risk isn’t only to human life. Already, one Chinese airline announced it was cancelling flights into Tokyo after it heard that radiation was spreading into the city.

If this is true, it means that radiation has spread 135 miles, into Japans most populated city. That’s a very bad thing indeed.

Everything is hedging on the outcome in Japan. Already, analysts estimate that the damage caused by the earthquake/tsunami combination will make this the most expensive natural catastrophe since hurricane Katrina put the city of New Orleans under water. That tally does NOT include any radiation fallout damage we might see if the reactors have a full blown meltdown.

We’re heavily invested in Brazil right now, with over 44% of the portfolio dedicated to the country. If the financial aftershock starts to hit the Brazil market hard over the next few days, we’ll consider paring back our exposure there.

To be sure, the effect to Brazil has been minimal so far. The Brazil ETF (EWZ) was only down 1.31% on Tuesday. And we see perhaps another 5% of downside before Brazil-based stocks stabilize. That’s not enough for us to liquidate our holdings, but it is something to keep in mind.

The last thing we want is to issue a “sell recommendation” on a long-term position based on short-term news. For all we know, this nuclear problem in Japan could boil over next week, and international stocks could boom as a result. Or it might turn into something worse. Only time will tell.

As for US based stocks, the downtrend we’ve been pointing out to you for the past two weeks, continues. The charts tell the story…

The Dow Jones 50-Day Moving Average Break is Significant

The break under the 50-day moving average in the Dow Jones has been quite significant. But the index is heading towards its first level of major support – the previous high of May 2010 of around 11,250. From there it will bounce higher.

S&P 500 and Nasdaq Have a Support Line at May 2010 High

Over the short-term, the trend in the US markets is down. And while we have identified possible reversal points, we shouldn’t discount the news out of Japan as a catalyst for further drops.

In fact, if over the next few days we hear that the leak is growing and radiation is spreading further across Japan, the market will drop more.

This is a very volatile situation – one we’ll pay close attention to over the next few weeks to help you protect your investments. After the last earthquake hit Japan, the Nikkei dropped 25% in the first three months. Already the Nikkei has fallen over 21% in just three days. We wouldn’t be shocked to see a 40% total drop in the Nikkei by the time the selling stops.

The game plan is essentially this: once the panic about Japan reaches a fever pitch, we’ll look to invest strategically. Be ready.

Until then,

Charles Del Valle
Co-editor, Strategic Investment