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Has the latest pullback in precious metals and related stocks given you a sickening feeling in the pit of your stomach?

If so, then consider rebalancing – because that sinking feeling is a good signal that you are probably overinvested in the sector. I’ll have more on that topic in a moment, but first to the question of where to invest, if not in precious metals and resource stocks? That is a question we get quite often.

For the time being, as least for those without international obligations, the carrying cost of cash is very low. Thus you can reduce your near-term risks, albeit at the cost of forgoing upside. If at one end of your portfolio “barbell” you have a 20% to 33% allocation to precious metals, having the same sort of allocation to cash on the other end of the barbell brings overall risk down while giving you the liquidity to act as additional opportunities arise.

As for the “middle,” consider building a portfolio diversified between undervalued food and energy stocks (constant needs) and high-potential tech stocks.

I include the latter because tech is one of the few remaining sectors where U.S. companies still have an edge. Secondly, the infusion of money from QE2, QE3, and so on, will almost certainly have a positive effect on the broader U.S. stock market. While not a direct correlation to the situation today, as you can see in the chart just below, Japan’s predecessor experiment in quantitative easing clearly produced a dead-cat bounce in that country’s stock market. As you can also see, almost immediately after pulling the plug on the QE, the stock market fell back to depressed, pre-QE levels.

click to enlarge

The importance of this information is two-fold:

  1. It suggests that as long as the government keeps a heavy foot on the money-printing pedals, the U.S. stock market should, if nothing else, maintain. While we will almost certainly see a lot of volatility and perhaps sector-specific crashes – for instance financials, once the scale of the toxic loans becomes more visible – the broader market should be able to avoid a crash. Of course, once the plug is ultimately pulled on the Fed’s monetary madness, as it inevitably will be, then watch out below. But based on Bernanke’s latest comments, that appears anything but imminent.

  2. With the risks of a broad market meltdown greatly diminished, investors – large and small – will be less afraid of piling into specific sectors that they feel have significant upside. That will feed into a bubble in the mining shares and drive up other sectors, including tech stocks. The world loves the latest and greatest, and the stories of the big tech winners are just so damn juicy that they regularly make news in all the right ways.

I recommend this because we continue to receive a large volume of emails from readers sitting on big profits in the precious metals and related stocks. They love what the stocks have done to their portfolios, but the size of their gains leave them nervous about a big correction, or worse. Offsetting those concerns is the clear upside in the sector (at least clear to us) – gains yet to come as currency regime change unfolds and the fiat currencies are eventually replaced with something far more tangible.

The precious metals stocks are going to have a particularly wild ride in the months and years ahead. While the overarching trend will be akin to a moon shot, there will be any number of heart-stopping corrections along the way. And looking at the current price action, we may be on the verge of one now.

Depending on your personal investment style, there are a couple of simple approaches you might want to take to that end of the barbell you have dedicated to the precious metals.

  1. Trade the markets. Buy on our recommendations, but sell on big surges – for instance, of the sort we have seen of late. Wait for the next correction to reload and do it all over again. Of course, this gives rise to the possibility of missing a really, really big move. Which brings up…

  2. Know what you own, and hang in there… at least until a hard exit target is met. I personally have owned several holdings for years. Not because I view them as heirlooms, but because they keep surmounting each successive hurdle on the way to production or, more likely, a buyout. During corrections, as often as not, I just buy more.

  3. Use trailing stops. Because these stocks are very volatile, though, you are probably going to want to be fairly generous in where you set your stops… 15%, 20%? Otherwise, you could get knocked out at the wrong time, for the wrong reason, and miss the quick bounce. Also, it’s important to remember that the juniors are especially thinly traded. That’s important, because if your trailing stop is hit, your shares will be sold “at the market”… in other words, for whatever someone is willing to actually pay for them. Thus, on a really bad day, your stop limit could be triggered… but your stocks find no bid and plummet, eventually changing hands far below your limit.

    (If you work with a good broker, rather than putting your order into the system to be blindly sold at the market if your stop is hit, they’ll agree to keep it “on the desk.” Which means that if your trailing stop is hit, they’ll actively begin trying to work your stock into the market for the best possible price, as opposed to blindly dumping the entire position at the bid, wherever that might be.)

  4. Sell puts. If there is a stock you like and would like to own more of, consider selling puts – which contractually obliges you to buy a certain stock at a certain price, if it hits that price. In exchange, you receive a commission. As long as the stock is moving up, sideways, or even a bit down, you are off the hook, having earned a nice commission for your guarantee. On the other hand, if the stock falls to the point that it gets put to you, then you’ll be forced to buy it, but at a cheaper price than the current market – with your net cost lowered further by the commission you received. Again, however, in a freefall, you could be forced to buy more of a stock at a price that is well over the then-current market.

Those are just the broad strokes, and there are of course additional strategies you can use to mitigate risk while continuing to seek the explosive upside of the sector. But, again, I have to say that no matter what strategies you deploy, the only way to keep a cool head in the face of potentially extreme volatility will be to invest only with money you can afford to lose at least half of. Over-investing in the sector will make you far more prone to panic and bad decision making.

And if you have enough of an allocation to the precious metals and enough cash, then you can look for other sectors with big upside and with a downside risk that can (mostly) be managed with thorough due diligence and in-depth industry knowledge.

Source: Consider a Rebalancing Act for Your Portfolio