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Published: August 25, 2009
With the very real possibility that the stock
market recovery has outrun the global economic rebound,
investors need to consider defensive investments that will
provide protection and even some profits should some of the
world’s top stock markets take it on the chin.
To be sure, stock prices in many of the markets around the world
have come a long way since March. Investors who stood and
watched as their portfolios were eviscerated last year have
actually recovered at least part of their losses.
But now it’s looking like stock prices in some markets have
risen more than was warranted – some of the hottest Asian
markets appear to be overvalued – which means that it’s worth
looking again at defensive investments that can protect
investors from another stock market downturn.
There is no foolproof way of protecting your money against a
market downturn. But a mixture of international investments,
gold, put options and high-yielding dividend stocks will help
you sleep better at night. Just as importantly, those
investments will also behave decently even if the market doesn’t
crash.
Traditionally, the most frequently used defensive investment has
been to keep cash in bank deposits or money market funds.
However, with short-term interest rates at zero and inflation
still between 2%-3%, keeping funds in cash is a recipe for a
slow erosion of its value. What’s more is that inflation is
likely to creep up substantially before the U.S. Federal Reserve
gets serious about raising interest rates, so that value erosion
could become substantial.
Also, if short-term rates and inflation are both running around
5%, the saver still will lose, because he or she will have to
pay taxes on the interest received and will get no tax reduction
to compensate for the value lost to inflation.
The likelihood that inflation will resurface makes bonds an even
worse defensive investment. The income is usually fully taxable
and it probably won’t cover the cost of inflation. (Municipal
bonds are tax-free, but subject to the currently deep dangers of
U.S. state and municipal finance.) Even the nominal principal
value of those bonds will decline if interest rates rise.
There are a number of reasons why long-term interest rates may
rise. In fact, I can think of three offhand:
* Inflation and a rise in short-term rates could push the whole
yield curve upwards.
* Government deficits may become hard to finance, which will
force up Treasury bond yields.
* The Chinese and Japanese central banks – and other big holders
of Treasury and housing bonds – may get fed up with the low
returns and uncertain currency outlook. They could sell their
U.S. bonds and replace them with euro, yen or renminbi (yuan)
bonds.
So, if the choice were between long-term bonds and cash, I would
recommend cash.
The traditional investor remedy for inflation is gold and
gold-linked investments. I would certainly recommend moderate
holdings of these, but would avoid a complete devotion to them.
For one thing, the gold price is already high by historical
standards, and perhaps a little risky. There must be some chance
that the global recession will be deeper and more prolonged and
inflation more timid than I project. So, holdings of metallic
gold, gold-mining shares and other precious metals such as
silver, platinum and palladium should be no more than 20%-25% of
your portfolio.
Another good way to hedge against risks in the U.S. stock market
is to buy international stocks.
India’s market, in particular, looks slightly overvalued at 20
times earnings. The lowest Price/Earnings (P/E) ratios are in
Russia and Venezuela, but with the problems and issues they
face, it would be silly to invest in either of those countries
today.
Countries like Finland, South Korea and Germany are, perhaps,
the most attractive. Their budget deficits are well under
control and their economies are showing signs of renewed
expansion. It’s well worth thinking about a modest
diversification into the markets of nations that have been
notably distant from the toxic assets that led to last year’s
financial meltdown.
In recent years, inverse exchange-traded funds (ETFs) have
become popular hedging mechanisms. These typically take a short
position in stock index futures, so their share price rises when
the index falls.
There are two problems, however. The obvious problem is that
these ETFs are vulnerable to a rise in the index. The less
obvious problem is that because the funds must rebalance daily –
according to the amount of shares in the fund – they can
accumulate “tracking errors,” which means that they end up
rising less than the index falls.
Even the Rydex Inverse Standard & Poor’s 500 Strategy Fund (RYURX),
which has been running since 1995, is currently only around 10%
above its 2000 low, while the Standard & Poor’s 500 Index is
more than 30% below its 2000 high.
This problem is much worse for
so-called “leveraged inverse funds,”
which are supposed to move two or
three times as much as their index.
These can accumulate tracking errors
at an alarming rate – especially
with highly volatile indexes in
overseas markets. For less volatile
indexes, such as the ProShares
UltraShort 20+ Treasury Fund (NYSE:
TBT), the tracking error is much
less.
Nevertheless TBT is only a
moderately good hedge against rising
interest rates, unless that rise
happens quickly.
The best way to hedge against a huge
bear market, like that of 2007-2009,
is to buy long-dated
out-of-the-money put options on the
Standard & Poor’s 500 Index (SPX).
These are traded on the Chicago
Board Options Exchange (CBOE). You
can buy these out to December 2011,
and those with strike prices of 500
or 600 are currently reasonably
priced, at $23 and $38,
respectively. To get the value of
the actual contract, you multiply by
100. So, for example, $3,800 will
buy you an option to sell the SPX at
600 (so 100 units represents $60,000
of stock) in December 2011. Then, if
at some point before December 2011,
the SPX is trading at 450, you will
sell your options, receiving
something north of $15,000 for your
$3,800 investment.
As with gold, your investment in
these options should be limited –
perhaps to no more than 5% of your
stock portfolio. However, they can
have the great advantage of
providing investment cash and
morale-boosting profits when the
market gets hit and is truly
depressed.
Finally, you can adjust your stock
portfolio itself by buying stocks
with strong dividend yields. These
will fluctuate with the market, but
the dividends they give off will
provide you with an additional
return, over and above the current
measly 2.6% dividend yield of the
S&P 500 Index. Moreover, that return
will generally rise with inflation
(as the company’s sales and earnings
rise in dollar terms) so your high
income will be much better protected
against inflation than you’d be if
you were relying on income from
bonds.
High dividend stocks, whose
dividends are covered by earnings,
are typically also low-P/E stocks.
Thus, by buying them you are buying
at the “value” end of the market
where bubble-induced overvaluations
are less of a risk. In my view,
however, a low-P/E stock that pays a
high dividend is greatly preferable
to one that doesn’t. That’s because
management is giving shareholders a
chance to reinvest the money, rather
than keeping it to spend on crazy
expansion schemes or their own
perquisites. There is also less of a
chance for the company’s earnings to
be fudged through some funny and
complicated accounting quirk.
-- Martin Hutchinson
Contributing Editor
MoneyMorning.com |
