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With zero job growth, a US economy teetering on the brink of recession, and a dismal European sovereign/bank outlook, I think it is time to be positioned for further market weakness. I read a lot about the mess that the world is in, from all fronts: economic, fiscal, monetary. Growth is slowing, a recession seems to be looming, and fear is creeping into markets. But nowhere have I read how to balance a portfolio to preserve capital, and still try to make a little money given where we are today. Riding out the storm by simply holding all equities could be a fruitless endeavor. It certainly was over the last 10 years. And that is not adjusted for inflation.

I do think that certain stocks have gotten very cheap, and you should own them, but it’s important to position your portfolio for continued weakness in equity markets. And that includes balancing value equities with bonds, precious metals and select short positions.

Equity Exposure

I think the first obvious means of protecting your portfolio is to look at your equity exposure levels. I have been running approximately 30% net long stocks for most of this year. I missed quite a bit of upside in the first quarter, but also missed a lot of the recent downturn. You simply cannot be long too much right now; keep some dry powder. I actually bumped up my exposure a bit recently, but am still cautious. Yes, the equity markets are somewhat cheap, but the news flow from Europe and the economic news from the US shout out caution.

If you find that you are 40% long, perhaps short some S&P 500's (SPY) or buy puts on individual names to bring your exposure down, it’s generally how I like to manage risk. Avoid the double short levered ETFs however, the time decay and leverage costs hurt performance over any extended period of time. Stick with SH or shorting SPY directly.

Avoiding Financials

I also recommend avoiding financials. Our own government is suing 17 banks including Goldman Sachs (GS), Bank of America (BAC), JP Morgan (JPM) and Deutsche Bank (DB), among others. In addition to terrible litigation and regulatory risk, banks simply are over-levered entities with piles of mortgages and loans. Not what you want to own in a recession and in an awful housing market. With smaller proprietary trading books post Frank-Dodd and diminished loan activity given our economy, the revenue picture for financials doesn’t look good either.

Finally, the next shoe to drop is likely a European banking crisis, which will perhaps create another liquidity panic in the financial markets. While US banks look bad, many of the European banks look even worse. The WSJ has reported that some 44% of money market funds in the US own European bank debt in some capacity. Contagion could get ugly.

To give one example, take a look at France’s biggest bank, BNP Paribas. Its equity is down 38% over the past year. It is heavily long PIIGS debt and levered 25x (leverage to tangible equity). In fact, on its 74BB Euros of tangible equity, it has a whopping 50BB Euros of exposure to the PIIGS plus Belgium! This debt is likely worth 30-70cents on the dollar. Marking to market and absent a Eurobond rescue, BNP looks like it needs to raise billions in capital. And it’s not a small bank either; its balance sheet is almost 2 TRILLION euros. That is bigger than Bank of America’s! A failure here could trigger awful financial contagion ala 2008. A system whereby massively levered banks own near insolvent, over levered sovereign debt is a disaster waiting to happen.

Defensive Stocks

Food stocks, staples, healthcare and dividend paying big cap names look decent to me. Names like Wal-Mart (WMT), Kraft (KFT), Procter & Gamble (PG), Johnson & Johnson (JNJ) should do better than smaller cap, industrial and cyclical names. In fact, these four names sport dividend yields on average of 3.3% today, far better than what you get by owning ten-year Treasuries. Which have awful credit and inflation risk by the way. You cannot be long US long dated bonds at 2% in my opinion. I am not saying don’t own energy and industrials, but keep exposure light.

Precious Metals

Importantly, gold, silver and platinum too have offered a nice buffer to declining equities. No doubt, the road of most G-7 countries is to print money, and without a reserve currency that is truly safe, I think central banks with capital will continue to own gold instead of fiat funny money. I think if you don’t have 10-15% of your assets in precious metals, you could face serious currency devaluation risk. Even if you are of the mindset that gold is in a bubble, just realize that you cannot NOT own it!

If you are worried about gold prices, buy some platinum instead (via physical or PPLT). Platinum has performed quite poorly this year, only up 5.6% year to date versus GLD and SLV, which are up 32% and 49% respectively. It's 15x rarer than gold yet trades at parity with gold now. Its historical ratio to gold is between 1.5 and 2.0 times. Even better, the administrator of PPLT holds its platinum in Zurich and London, eliminating confiscation risk.

I also think adding perhaps a decent gold mining company isn’t a bad idea. To a certain extent, cost increases (notably diesel) among the miners has prevented them from performing as well as gold lately. But with oil falling, it’s good now to own a long gold, short oil play to some extent. Newmont Mining (NEM) is trading at 13.3x TTM earnings, against an historical P/E of 29x. That is an average going back to 2002. It’s a decent macro play with a reasonable valuation, pays a 1.9% dividend, and generates 19% returns on equity.

So, keep 10-15% of your assets in precious metals in some fashion. You cannot miss this boat, it’s a virtual guarantee that the US, Japan, England and the ECB will have no choice but to print money to fund massive deficits. And with that, precious metals will continue to be in demand. Concerned about timing GLD? Just wait and buy it below its 30-day moving average. That system has worked extremely well in the past 5 years.

Bonds

With 30% in equities, 10-15% in precious metals, what should you put in bonds? My answer is about 35%, leaving the rest in cash. Keep this cash to buy when panic takes hold again, and everyone is scared out of their minds. Consider a mix of the following fixed income:

Emerging Markets Bonds. In the sovereign debt world, I would avoid not only US Treasury debt but also European sovereign debt. Given that the dollar’s path is continued devaluation, the only sovereign debt I recommend are those in Emerging Markets. Bond funds like CEW and/or PIMCO’s PLBDX are good examples, and held up quite well in 2008. These will benefit as the dollar continues its path toward non-reserve world currency status.

Eventually too I suspect that Euroland will have no choice but to create a united Eurobond, despite objections from the Germans. At the end of the day, Germans will realize the choice will be twofold: a banking collapse in Europe including German banks that hold sovereign debt, or the Germans agreeing to use their balance sheet to backstop the rest of the continent. If the banking system falters, then nobody buys BMW’s or Audi’s. Meantime, avoid Euro sovereign debt and invest in EM sovereigns with decent balance sheets.

Corporate Bond Funds. Beyond an EM fund, I would recommend a corporate bond fund. My favorites are the iShares iBoxx Investment Grade Corporate Bond ETF (LQD) and iShares Barclays 1-3 Year Credit Bond ETF (CSJ). These are high grade, low yield perhaps, but reasonably safe with limited duration risk. CSJ owns 1 to 3 year maturity corporate bonds on average, and even though the yield is a meager 2.1%, corporations are in far better financial shape than the US government, whose 2 year bills only yield 0.2% right now. Owning short-dated Treasuries is certain to lose you money once inflation is factored in.

LQD yields 4.6% right now, and does have some duration (ie rate) risk, but owns quality investment grade bonds from AT&T (T) to Wal-Mart (WMT) to JP Morgan (JPM). Spreads aren’t great in IG corporate bonds, but year-to-date LQD is up 6.5%, about the same as its 5-year average annual return. Some may argue that we’ll see a further widening of corporate spreads, but if we do (because of a recession), you will see treasuries yields fall even further, propping up investment grade bond prices.

Bank Debt Funds. Another decent fixed income option is a bank debt fund. It’s virtually impossible to buy bank debt directly, so look for a fund like Fidelity’s Floating Rate High Income Fund, ticker FFRHX. Or a closed-end fund such as Eaton Vance’s Floating Rate Fund, (EFT). Eaton Vance’s NAV is only down 1.8% year to date, but its stock has traded down 8% year to date! Retail holders are clearly exhibiting signs of panic, and this is on that if there is more panic, will get sold mercilessly. Take that as warning, but also as potential opportunity. In good markets, CEFs like these often trade at premiums to NAV (hint, sell), and in bear markets, sell at large discounts to NAV (hint, buy).

The best news is that bank debt is virtually duration-free. There is spread risk, but bank debt rates are floating. If LIBOR goes up because Fed Funds rates go up, then your coupon adjusts accordingly.

High Yield Bonds. High yield is actually getting interesting, with yield spreads around 800 basis points. However, as Merrill Lynch noted recently, every time HY spreads widened over 800 bps, further widening ensued. We may see more weakness, but probably it’s time to buy a little with a goal of adding more down 5-10%. ML notes that:

  1. HY fell 35% from peak to trough in the last recession, June 2007 to December 2008.
  2. HY recovered all of its losses by the end of August 2009. You definitely could not say that about the S&P 500 or the Dow.
  3. Cash as a percentage of short term debt at HY companies is around 185%, nearly twice what these companies held as they entered they entered the selloff in 2009.
  4. Default rates are forecast to increase from 1.5% to 3.0%, still low by historical standards. Higher corporate cash balances are an advantage, and HY firms remember well what happened in 2008.

Tickers HYG or JNK are exchange traded funds that you can buy quite easily. HYG has slightly outperformed JNK, and today yields a little over 8%. Its 3 year average NAV has grown by 8% per year, and it was down 23% in 2008, far less than the S&P which fell 37%. Start nibbling here.

Trading Strategy

It’s really impossible to know where the markets are going over the next three months. Risk factors feel to me more like they felt in summer 2008, before Lehman went bankrupt. Weak economies, talk of recession, potential bailouts of huge banks like Soc-Gen and Unicredito, undercapitalized bank balance sheets. On the plus side, US markets are slightly cheap now at 12.5x earnings but it can get a lot cheaper.

As for upside catalysts, we need QE3 and some kind of resolution in Europe. Both are a matter of time. Meantime a banking/sovereign debt panic out of Europe will create buying opportunity, but it’s unclear how close to the brink the Germans will go before they cave to a Eurobond. Or how long it takes before the ECB simply begins to print Euros to fund fiscal deficits there. Or worst case, the Euro unravels entirely. A Eurobond requires fiscal unity in Europe, not just monetary unity, and this is very complex issue.

But generally the announcement of QE3 and some kind of Euro resolution (a unified Eurobond perhaps) is likely going to be a good time to add exposure in cyclical and commodity names. Some speculate that the Fed may merely announce a quantitative easing plan that is far smaller in scope than a blanket six-month program, as was done with QE1 & QE2. Markets may view this is not good enough. QE programs so far haven’t helped housing or unemployment or the economy really. But either way, eventually it is a near certainty to get QE3, and hints of it, or the announcement of it would be a time to add more risk (equities) to your portfolio.



Disclosure: I am long WMT, KFT, CSJ, GLD, PPLT, EFT.

Source: Positioning Your Portfolio For A Bear Market