Six years into a bull market for stocks and bonds, there is
no shortage of reasons to prepare for trouble. U.S. stocks are close to their
most expensive levels since 2004, even as interest rates seem headed higher.
China’s economy and financial markets have turned fragile, Brazil is under
pressure and a bailout of Greece might not work. The U.S. tech-stock boom could
go bust and high-profile investors are gearing up for a crisis in the expanding
world of exchange-traded funds.
Whether one agrees that stocks are approaching bubble
territory or not, well-planned investment portfolios require a dose of
protection. Currently there are few obvious ways, however. Gold prices keep
falling, safe investments have puny expected returns. Bonds with any risk
attached to them increasingly move in the same direction as stocks, reducing
their ability to hedge a portfolio. Below are some potential storms on the
horizon, and possible ways to prepare for them.
Tech Stocks Pull Down
the Market, Again
The stock market is up so far this year, led by tech stocks.
But the sector is rising on the backs of just a few stocks. When relatively few stocks are leading the
way, trouble could be around the bend for the entire market. That is what
happened in early 2000 when highflying tech shares soared and then collapsed.
Today, one or two ugly earnings reports from the tech titans could be enough to
disrupt the broader market.
The Solutions: Bold
The first defensive move is to make sure a portfolio isn’t
overcommitted to technology or any single sector, of course. But shorting, or
betting against, tech shares can be dangerous. These stocks could keep
climbing, crippling any bearish trades. Instead, some advisers recommend active
investors buy long-term “put” contracts on PowerShares QQQ Trust Series 1 (symbol
QQQ), a heavily traded ETF tracking the tech-intensive Nasdaq-100. These put
contracts, which give holders the right, but not the obligation, to sell the
index at a set price, should appreciate in a market downturn.
For all investors, including those mainly in the market
through a 401(k), holding safe investments is a must. A smattering of cash, CDs
and short-term Treasurys can help stabilize a portfolio in a crisis. They also
discourage investors from dumping riskier holdings with better long-term prospects,
says William Bernstein, an investment manager and author in Portland, Ore.
China Goes Downhill
and the Greek Bailout Fails
The Chinese stock market is down about 31% since mid-June,
the worst performance in more than eight years. If troubles persist, questions
could grow about the Chinese government’s ability to steer the debt-laden
economy. Meanwhile, investors are increasingly nervous about Brazil’s weakening
economy, and Europe’s agreement regarding Greece’s debts might not have more success
than two earlier bailouts.
If geopolitical events cripple the market, a fund that
sticks to low-volatility stocks, such as PowerShares S&P 500 Low
Volatility ETF (SPLV), could hold up well. But the biggest payoff likely
will be from investments that rise as the market’s volatility surges, argues
Robert Gordon, president of Twenty-First Securities Corp. in New York.
These strategies aren’t for novices. Mr. Gordon recommends call
options—which give holders the right to buy shares at a specified price—on the
volatility index known as the VIX. These options can be bought through any
brokerage. Options can move quickly and cause big losses or they can expire
Markets have faith in central bankers fighting to generate
global growth. In the U.S., the Federal Reserve is expected to begin raising
rates, though few expect a recession soon. But the recent slide in commodity
prices could portend a global economic slowdown, some say. And corporate bonds
could be hurt if the U.S. economy slips or the Fed raises rates at a faster
pace than economists expect.
Long-Term Bonds and (Gulp) Gold
As the Fed raises rates, investors should shift into—not
away from—long-term Treasurys, argue some managers, including Jeffrey
Gundlach, chief executive officer of DoubleLine Capital LP in Los Angeles.
Instead of reacting to Fed moves, these bonds tend to respond to forecasts of
inflation. Inflation currently is subdued and will face further headwinds when
the Fed raises rates.
Gold prices are down about 40% since peaking at nearly
$1,900 in 2011. But if markets lose confidence in the ability of the Fed and
other central banks to prop up markets, gold will perk up, predicts hedge-fund manager
Bob Wiedemer, who notes that gold tends to attract interest when doubts grow
about values of leading currencies. Just don’t keep more than a few percentage
points of a portfolio in gold, which generates no income or dividends, advisers
Bond ETFs Blow Up
Recently, high-profile investors including Carl Icahn warned
of a potential crisis in the expanding world of bond-focused exchange-traded
funds. Because Wall Street bond dealers play a smaller role in markets today, a
bond-market scare could spark a rush of selling by individual investors in ETFs
and mutual funds. In such a scenario, these vehicles could find they have fewer
buyers to sell to.
Mortgages and Bearish Bets
Sreeni Prabhu, chief investment officer of Angel Oak
Capital Advisors in Atlanta, recommends shifting to bonds that are less
frequently found in funds and ETFs, such as residential mortgages. One
mortgage-focused fund recommended by Maury Fertig, chief investment officer of
Relative Value Partners in Northbrook, Ill., is TCW Strategic Income Fund (TSI),
a closed-end fund with a chunk of its portfolio in residential and commercial
mortgage bonds, as well as other asset-backed bonds, investments that most
individual investors have limited access to. Today, lenders no longer court
risky borrowers, making the mortgage market safer than in the housing crisis in
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