Tags: Martin Hutchinson

The Secret to Building a Portfolio that Pays - in Good Markets and in Bad

By , Money Morning •

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.

[Editor's Note: When it comes to global investing, longtime market guru Martin Hutchinson is one of the very best - because he knows the markets firsthand. After years of advising government finance ministers, crafting deals with global investment banks, and analyzing the world's financial markets, Hutchinson has used his creative insights to create a trading service for savvy investors.

The Permanent Wealth Investor assembles high-yielding dividend stocks, profit plays on gold and specially designated "Alpha-Bulldog" stocks into high-income/high-return portfolios for subscribers. Hutchinson's strategy is tailor-made for periods of market uncertainty, during which investors all too often go completely to cash - only to miss some of the biggest market returns in history when market sentiment turns positive. But it can work in virtually every market environment.

To find out about this strategy - or Hutchinson's new service, The Permanent Wealth Investor - please just click here.]

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