1 October 2020

Be Ready for the Next Investing Crisis

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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 and Boring 

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.

The Solution: Volatility Plays 

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 worthless.

Central Bankers Bungle It 

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.

The Solutions: 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 warn.

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.

The Solution: 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 2008.

Click here to access the full article on The Wall Street Journal. 

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