CHICAGO (ResourceInvestor.com) -- Anyone who has been paying a lick of attention to the world at large should be rightfully concerned about the health of their financial portfolios. While market watchers loudly proclaim that 2008 will be another “strong year” for domestic equities and mainstream economists downplay the risk of recession, the economic reality observable by the man on the street is quite clearly troubling.
For anyone who has any industry experience in the mortgage markets or leveraged finance (this correspondent included) it’s quite clear that the excesses of the past several years will take significant time to work off - and will strongly impact the “real” economy in the process.
Ignore the “Experts”; Invest With Common Sense
While there are certainly some bears rumbling at the periphery, much of the Wall Street selling machine continues to call for “double-digit gains” in 2008, often touting the market’s relatively undervalued P/E ratio. Looking at this one (often useless) measurement alone, however, reveals much to be concerned about. While the market’s backward looking P/E is certainly relatively low, any prognosticator who uses this as a reason to invest is overlooking one crucial point: After normalizing profit margins only to historical averages, the “E” portion of the ratio sinks quite dramatically, making the markets look much less favourable. When one factors in (and extrapolates) the type of losses currently being seen from all major financial institutions these days (which make up approximately 20% of the S&P 500), the picture is considerably more bleak.
Investment bank economists also continue to tout the “underlying” strength of the domestic economy. But economics isn’t called the “dismal science” without reason. While economic common sense is immensely valuable in explaining how and why individuals and firms make rational business decisions, many economic prognosticators have a woeful track record in predicting future events. Given that the entire field is often predicated on the usage of backward-looking indicators and data - rather than common sense future observations/predictions - this isn’t terribly surprising.
Steps to Insulate Your Holdings
This isn’t to necessarily say that a bear market is around the corner; it is just to make the point that anyone who doesn’t protect their assets at this stage in the game does so at their own risk.
Pare Winning Resource Investments
It’s probably prudent to pare back winning base metal- and energy-related investments made over the past few years. While the prospects of a continued dollar declines could certainly help to keep commodity prices strong, a major U.S. slowdown will undoubtedly impact these markets to the downside. While many are hoping for an emerging market “decoupling” where EM growth remains strong, the nature of globalization will ensure that a U.S. economic recession will at least cause some kind of hiccup in foreign growth - which could potentially hit commodities very hard.
Don’t Be Afraid to Hold Cash
In any uncertain market, “cash is king”. Don’t be afraid to keep upwards of 50% of your portfolio in cash or cash-like investments - this will leave you with plenty of money to deploy when the real bargains emerge.
Hedge up Your Holdings
If you’ve got large domestic investments that you can’t - or are unwilling - to sell, consider hedging up some of these risks with a bear market fund. Two of my favourites are Prudent Bear [Nasdaq:BEARX] and Leuthold Grizzly Short [Nasdaq:GRZZX]. Another great fund is Hussman Strategic Growth [Nasdaq:HSGFX], which ranges from 150% long exposure to market neutral based upon valuations and market action. Since it has never net short, this fund won’t do anything to insulate your current longs, but I’ve found it to be a great, disciplined alternative to holding “traditional” domestic equities (allowing me to spend more time researching and investing more in resource-related securities).
Use Risk Limiting Means to Diversify Into Non-Dollar Holdings
While a dollar bounce against certain currencies is certainly long overdue, any smart investor should have a portion of those aforementioned cash holdings spread across currencies with strong economic prospects. While banks like Everbank allow investors to purchase foreign currency CDs and there are many reputable short-term foreign bond funds, one of my favourite relatively low risk ways to diversify is through some of the structured products that currently trade (quite thinly) on the U.S. exchanges. A combination between a zero-coupon bond and call options on a basket of currencies, these notes typically offer principal protection in terms of the note’s face value, plus the benefit of upside gains should the dollar depreciate below certain thresholds. While not an avenue for high-octane gains, these notes provide a reasonable way to insure your portfolio. One example is Wachovia’s Principal Protected Note Linked to a Basket of Asian Currencies [AMEX:AWO]. This note, which currently trades at $10.40, expires in December 2008. At that time it will return a guaranteed minimum face value of $10 if the dollar strengthens past certain levels, or significantly upwards of that if the dollar weakens relative to several emerging market currencies. In short, it’s a way to gain some protection against significant dollar weakness with a maximum downside of about 3%! Of course, be sure to read the prospectus to understand fully how the returns accrue (there are some tax concerns inherent to zero-coupon bonds to be aware of) - and recognize that the note is structured as a senior unsecured debt of the underlying financial institution, so that if Wachovia were to go belly-up, you’re out your entire investment. More information about similar products (there’s a handful from various banks) trading on the American Stock Exchange can be found at www.amex.com under the “Structured Products” heading.
Hang on to Your Precious Metals
While it’s always natural to take some profits, don’t start bailing out of all of your precious metals investments anytime soon. While gold prices have had a strong run of late, there’s plenty of reason to believe further gains are in store in the coming months for precious metals mining shares. Shares are still relatively cheap (vis a vis the Gold/XAU ratio), and the economic fundamentals of growing inflation and weak industrial production (via the sinking PMI reports) have historically been extremely favourable for precious metals.
Use Bounces to Remove Risk - And Beware Falling Knives
As with any potentially emerging bear markets, there will be periods of dramatic short-covering rallies in the domestic indices. Use these wisely to take profits on short-term investments, and further insulate your holdings. Additionally, try to avoid the temptation to “catch a falling knife” on potential investments-– especially any within the financial sector. They don’t ring a bell at the bottom, and just as bull markets tend to run farther than most people anticipate, downside moves have a way of getting even more extreme. It’s far better to miss an exact bottom - and the first 20% of turnaround upside as fundamentals improve - then be stuck holding the bag on a asset dumped into a bottomless pit.
Conclusion
Of course, this correspondent probably knows as much (or as little) as any other market “pundit” out there. (But how many people will actually admit that?). Given the highly apparent risks (to all except Wall Street wonks) in today’s market, however, caution is the name of the game. And, last of all, don’t underestimate the important impact of investor psychology on a market. Concern can migrate to fear - and fear to wholesale panic - quite quickly, leading to dramatic declines in short periods of time. Make sure you’re prepared. If you can’t withstand losses of upwards of 30% on your current portfolio, you’re probably too aggressively positioned at this juncture.
