Raise Cash

When the investment markets turn downward it is time to get the defense of the field to protect your investment gains.  There are several ways to do that.  The first is to increase your cash or money fund levels.  This can be done by selling stocks and bonds and moving the sale proceeds over to the money funds.  In some 401-k funds it is called a cash or stable value option.  Remember none of us can predict the future so it is not generally the case of selling everything and going to 100% cash.  It is much easier to make the decision to increase cash levels to 10-20% at a time.  This reduces the pressure to be right every time and makes the decision much easier to make.  We raise cash for two reasons; to lock in a value preventing the investment from going down and also to have cash to make investments at favorable prices should the prices fall.

Move up the Investment Quality Scale

If you think that the market is heading for a correction or the economy is going into an economic slowdown then another tactic is to sell your lower quality investments because those are typically the ones that fall the most.  When the economy slows down companies with high debt, single products, and poor balance sheets tend to get in trouble.  Large multinational companies tend to be geographically diverse and can thrive in other countries if the economy slows down in the US.  Large cap multinationals generally have very high quality balance sheets that will allow the company to thrive and grow as the economy slows.  If you are in a 401-k plan with fewer choices, a simple rule of thumb is large-cap is higher quality than mid-cap or small-cap.  Economic slowdowns are much harder on small companies. 

Use Stop Losses

One of the best ways to protect profits and avoid losses is through the use of a stop loss order on some of your stocks.  A stop loss order is an order entered on the exchange that will trigger only if the stock hits a certain price set by you.  Once the stock hits that price your order becomes a market order and is executed automatically.  Stop losses should be used for stocks that you want to sell or are concerned about.  Some people put the stop order at 10% under their purchase price; others have a big profit and place the order to protect their profits.  As the stock moves higher you can just raise the price of the stop higher from time to time.  Another method is to use a mental stop.  In this case you set a price in your mind and on paper at which you will sell if the stock drops below that figure.  Most institutions use this method given the large size of their orders.  In this case it is often a good idea to stick with that stop and not talk your self out of it without a good reason. 

Avoid the Credit Crunch

In the Fixed Income or bond markets, quality is very important in an economic slowdown.  At MaxOut Savings Advisors we believe that we are witnessing a debt driven credit crunch that will reduce the value of low quality bonds.  We would not be invested in any investment banking bonds at this time.  We also would own little or no junk or high yield bonds.  We do not believe pricing has fully worked in the economic slowdown or debt problems.   Quality is now king in fixed income and across the bond sector.  The high quality bond fund investments are US government bonds and US agency bonds.  Also high quality corporate and foreign government bond funds look attractive.   Tax free or municipal bonds are generally much higher quality than most bonds given the inherent taxing ability of many state and local governments to pay off the bonds.  We would be very careful of insured bonds as many of the bond insurers are now in financial trouble for insuring mortgage debt.  We have seen problems at MBIA, AMBAC, FIGIC and most other bond insurance groups.

Increase Fixed Income Weightings

Risk in an investment portfolio can be reduced by increasing the percentage of fixed income or bond funds and thereby reducing the percentage of stocks in the portfolio.

If you are 100% stocks in your investment program, now might be a good time to look at adding a bond component to your portfolio.  At MaxOut Savings Advisors we typically manage our client’s investments with a 60% stock / 40% bond portfolio weighting.  When meeting with people after the 2000 Tech Crash we found that a large portion of their losses could have been avoided by a more properly balanced portfolio.  What is the stock to bond percentage for your portfolio? 

Move into Healthcare and Stable Demand

If the economy slows down people still need healthcare and food.   Most stock market declines are the result of economic slowdowns, real or imagined.  In those markets the stocks that tend to outperform are companies that are economically insensitive to a slowdown.  This would be the food groups, beverages, household products, drugs and healthcare.  These groups are known as stable demand and in a market correction and economic slowdown, they tend to out perform.  Some examples of these stocks are KO, BUD, PG, KFT, JNJ, PFE and HSY. 

Diversify Out of the US

One way to avoid the effects of a correction in the US markets is to invest overseas.  Most foreign countries do not have the huge debt and real estate problems the United State is now facing.  As we have talked about in the MaxOut Savings Report, the US dollar has declined over the last two years against almost every currency in the world.  That has resulted in overseas investments and companies doing business overseas outperforming domestic investments.  It appears to be a bit late to be investing overseas in some countries.  With the Euro as high as it is we would be cautious about investing in European stocks as the high Euro could hurt some companies.  The same can be said for Canadian and Australian stocks.  The Japanese Yen and stock market should outperform vs. the US as we still feel the Yen is undervalued.  Diversification out of the US can also be achieved by investing in US multinational companies.  The multinationals are typically large cap companies that conduct a large percent of there business overseas.  This allows for their profits to grow as the dollar falls.  

Avoid Investment Over-Concentration

During the Tech Bubble collapse the biggest reason for the 50-80% losses in portfolios was massive over-weighting in technology stocks.  Overexposure to one industry group can often set the stage for large losses in the portfolio.  This is something many of us living in Houston, Texas need to guard against.  If the portion of your company stock or an energy industry group becomes too large of a part of your portfolio, there is nothing wrong with selling some of the stocks.  Often times people build up large positions in the company stock through savings and stock options.  These positions can become most of your wealth.  We have personally seen people worth tens of millions of dollars lose most of it because energy prices plunged and the company ran into problems.  We can rarely see into the future so it is a good idea to diversify some of your assets.  Selling a portion of a stock is an easy decision when it is based on over-weighting.  A 30% weighting of an industry or 20% of one stock in a portfolio is generally considered to be a high concentration.  If you are concerned about an overly concentrated portfolio, look to sell some of the concentrated stock to reduce your risk.  If you have doubts about this strategy remember the lessons of the Tech Bubble. 

Look for Dividends

Look at dividend paying stocks.  Stocks that pay a good dividend tend to perform better than non-dividend paying stocks in a bear market.  The dividend will boost your return even if the stock does not move.  If a stock is paying a 4% dividend and moves up just 15% for the year that gives you a 19% total return.  One sector we would advise caution on in regard to dividends are the financial stocks as we could see some of the lower quality companies cut their dividends.  Remember dividends will boost your total return. 

Mortgage CMO Prices Continue to Fall

The following chart of the ABX-HE-AAA 07-2 index is an index of AAA rated tranches of mortgage securities from 2007.  This is the highest rated mortgage index group that is in many SIVs (Structured Investment Vehicle) and Hedge Funds.  From the chart we can see that the price has gone from 99 on July 19 to 70 on November 8.  This is why many of these SIVs we have heard about are in trouble.  Citigroup (C) is rumored to have $80 billion in these programs that are off the books.  This loss in mortgage derivative securities from 99 to 70 cents on the dollar has resulted in huge losses for the banking and brokerage businesses.  The losses now appear to be in excess of $200-400 billion across the financial system worldwide.  Up to this point only a portion of these losses have been recognized.  This is why we have seen the substantial declines in the banking and brokerage stocks. 

ABX-HE-AAA 07-2 Price chart