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This is a followup to a previous postings suggesting how investors can take refuge in the oncoming financial storm. If you've not done so already, be sure to read my previous post Say It Ain't So for a description of our dismal macroeconomic picture.

The purpose of this article today is to explore any safe havens for your investments to shelter them from this worldwide slump. What are we protecting against? Problem is, we don't yet know. And we won't until the elections play out next year, and events in Europe unfold.

The market may not wait for the politicians. Technical indicators suggest a very large correction in the market can be expected, and fundamental macroeconoomic trends unfortunately offer no consolation.

How severe will the downturn be?

In my view, that will depend in part on what fiscal and monetary policies we pursue, and how international political relations progress. There my crystal ball is a little cloudy.

Scenario one sees a continuation of monetary easing, as pursued by both the Bush and Obama administrations, and largely aped by European governments to a lesser degree.

In this scenario, the policy response will be pure Keynes, with large bouts of government spending to build out our country's infrastructure and hopefully create jobs. The Fed will assist with gobs of money dished out to offset rapidly deleveraging private expenditures and to support our wobbling real estate market.

The effect? A slow, but steadily dropping economy, with slow to negative GDP growth and a mix of high inflation and deflation. Prices of commodities, such as oil and food, will rise. So will gold and silver, by the way.

Why deflation? Because real wages will decline both in absolute and relative terms, as will most cyclical consumer goods, real estate and capital goods. Ever been to a third world country, where you can find a live-in maid for $100 a month, but the cost of food is double that of the U.S.? Well, that will be us.

Scenario two has U.S. politicians taking a page from the views of Friedrich Hayek of the Austrian school of economics. These teachings say that bubbles must be lanced, not nursed to larger and larger sizes. In this case, we're in for deflation only. Not inflation.

We decide we'll treat the credit addict (look in the mirror) with the Cold Turkey treatment. As we would withhold heroin from a heroin addict, we deny easy credit to consumers and banks, as opposed to a methadone-like slow withdrawal. So fiscal budgets are slashed 10-20%, military expenditures are capped and our troops are returned from their foreign war postings. The real estate market no longer is artificially buoyed up, interest rates are allowed to find their real value, and "budget deficit" becomes a derogatory term never even spoken in the presence of children.

Even the most ardent teapartyers admit that this strong medicine can be a harsh one to endure. Those of you who doubt that need only look to Greece's recent economic woes to see the effect on the GDP.

Since we'd be facing our pain earlier in this scenario, we'd also likely recover faster. But the market would fall hard and fast. In that scenario, we stop printing money, and the natural deleveraging of around $56 trillion of debt over a short period unleashes a wave of bankruptcies, foreclosures and bank failures.

Unemployment goes through the roof, wages decline rapidly, real estate drops back to pre-bubble levels, and the dollar strengthens as investors seek haven in the safest of world currencies. Gold and silver, suffer too, as they did in 2008 and in the crash of the Great Depression.

So where can investors seek shelter from this looming storm? Aggressive investors can go short, or buy reverse ETFs that make money as stocks plunge. They can sell deep out of the money puts of great companies, happy to buy these down the road at pennies on the dollar. But what about the average investor, who just isn't comfortable with trading or doesn't understand those complicated tools?

Here's my portfolio suggestions for that cautious investor, as well as the rationale:

(Click to enlarge)

The first and probably best choice is in mid-term Treasuries. A good exchange traded fund (ETF) for these is IEF (iShares Barclays 7-10 Year Treasury), but there are numerous good alternatives in the mutual fund world as well as in closed-end funds.

Note that in all stock market crashes, Treasuries have done well, with the longer term outperforming midterm and midterm outperforming short term, as one would expect. From 2008 to the bottom of the market in 2009, long term Treasuries posted 30% gains (NYSEARCA:IEI) while mid-term Treasuries advanced 25%. This is in addition to their yield.

I prefer the mid-term Treasuries to the longer term Treasuries for now because I still don't know whether inflation is a force to be reckoned with over the long term, or not, as described above. If we try to print our way out of this debt mess, long term treasuries will inevitably get killed as worldwide bond vigilantes punish the Fed's profligacy.

Treasure Inflation Protected Securities (TIPS) are also a good choice, at least for now. In a deflationary scenario, the bonds making up an ETF or mutual fund cannot drop below par. So even in a deflationary environment you will not see their net asset values drop much. You can expect some value erosion, because many of the bonds inside TIP are already trading at a premium. On the other hand, if we have inflation, these will be very popular and their small yield (around 1.9%) would augment commensurately, sending their Net Asset Value up.

Once you get clarity on the fiscal and monetary policies of the next administration, you will want to shift assets into or out of TIP to adjust for the inflationary/deflationary bias.

For those needing income, I look at high quality corporate bonds, and I prefer to buy these in the form of an ETF such as LQD (iShares iBoxx $ Investment Grade Corporate Bond ETF). You'll get a yield of about 4%. Note that you must be ready for a bit of a roller coaster ride, as these dropped by 18% in the last crash, before quickly recovering within 6 months. Generally speaking, the more risky the bonds were, the worse they performed. Three years later they were trading 60% higher.

Finally, another great defensive play are ETFs and mutual funds containing federally backed Mortgage-Backed Securities (MBS). These consist of Ginnie Maes, Freddie Macs and Fannie Maes [Freddie Mac (OTCQB:FMCC) and Fannie Mae (OTCQB:FNMA) are GSE's]. The attraction of federally backed mortgages is the elimination of the risk of default due to government guarantees.

PIMCO Mortgage-Backed Securities Fund INSTL (PTRIX) kept right on trucking steadily throughout the last 2008 crash, with only a slight 7% dip at its lowest point. I would expect it to do so in the next market crash. Its yield is currently around 2.9%.

For reasons of flexibility and nimbleness and cost, I prefer exchange-traded funds (ETFs) to mutual funds: a good play in the ETF sector is SPDR Barclays Capital Mortgage-Backed Bond ETF (NYSEARCA:MBG). At the time of writing, this is yielding about 3.87% with management costs of 20 basis points.

The risk with Fannie Mae's is that of refinancing. Most of these bonds are trading at a premium, sometimes a hefty one. If homeowners refinance, bondholders forfeit that premium they've paid. In an MBS, the Net Asset Value drops and future dividends decline. If the Fed continues to make aggressive efforts to coax down long term interest rates in order to boost housing, that's a real risk. (Remember, that policy is currently in force but may change under a new administration.)

Typically, real estate owners will not refinance for anything less than a 2% drop in interest rates, due to to the high costs of document stamps and mortgage interest, and other miscellaneous fees. Current 30 year rates are around 3.99% and 15 year rates are around 3.5%.

There are more than 8 million homeowners with mortgages issued through Fannie Mae and Freddie Mac who have loans carrying interest rates of 6% or more, according to the Federal Housing Finance Agency (source: money.com).

So if a large number of homeowners refinance over the next few years, mortgage-backed securities could be expected to decline. While I expect this to happen, I think it will be a gradual process, with no more than 10% of borrowers refinancing in any given year. I think the impact of this will be to reduce the overall yield of MBS instruments by 1-2% per year. However, this could be more than offset by the flight of investors to the relative safety of these holdings. So overall, I think investors could be looking at a real return of 3-5% on these mortgage-backed securities.

What if none of these awful scenarios play out? What if, miraculously, our next president pulls the proverbial rabbit out of his hat. The economy, riding on a new wave of confidence and enthusiasm, snaps out of its doldrums, companies hire and jobs rebound strongly? I consider such a scenario extremely remote.

But just in case, I would recommend holding a portion of your assets in a good structured CD investment. This could make up anywhere from 10% to 25% of your portfolio. Make sure it is FDIC-backed.

My personal preference is one holding commodity. Held to term, these investments have almost no downside risk (FDIC guaranteed) but have their upside capped around 10%. If the economy goes to hell in a handbasket, you get your principal back, which buys more goods and services than when you started.

If there is any growth overall in the world economy - even if the U.S. economy falters - commodities should rise, and you'll see a positive return.

Finally, I recommend to everyone a large holding in cash, I'd even recommend as much as 20%-30% of their portfolio in this form. This can be in the form of short term CD's, money markets, or savings accounts.

Why would you want to hold cash with interest rates at dismally low levels and inflation at around 3%? Remember, depending on how things play out in the next elections, deflation, not inflation, may be the wolf at the door. In deflationary times, cash buys you more and more each year.

Another reason for keeping cash is to avoid the need to sell an unusually depressed asset in an unexpected emergency. Having cash on hand obviates that need.

Finally, these are volatile times. Volatility also brings opportunity. In such times, I always like to have some of my powder dry, awaiting the next priceless opportunity.

Disclosure: I am long IEI, MBG, IEF, LQD.

Source: ETFs And Allocations To Protect Portfolios In The Current Financial Storm