How To Prepare Your Portfolio For Fed QE Exit

by: BubbleBustInvesting

"All nice things eventually come to end." So goes the old adage for everyday life. The problem, however, is that human beings usually forget it, as the emotional side of the brain (System 1 according to psychologists) loves the good things and wishes they last forever. This is especially the case on Wall Street when emotional investors join the party late, trading more on stories that circulate in the mass media than on hard data--like that the Fed will be accommodating forever.

The problem with this kind of mentality is that it can quickly swing in the other direction at the slightest hint that the story may not be correct. This was the case Wednesday afternoon, following the release of the last FOMC meeting minutes that hinted at a Fed exit from QE. How can investors prepare their portfolio for this prospect?

  1. Stay away from precious metals that have been rallying on the prospect of an infinite round of QE; and ETFs that invest in them like SPDR Gold Shares (NYSEARCA:GLD); iShares Silver Trust (NYSEARCA:SLV); Freeport McMoRan Copper and Gold (NYSE:FCX); and Palladium (PAL), as discussed in a separate piece.

  2. Stay Away from momentum stocks. Momentum investing is a strategy based on hype about an investment theme, a new product or a new industry that captures and captivates the investor mind-- at times when money is cheap. In the late 1990s, the theme was telecommunications and networking, with momentum funds flowing into companies like Ciena Corp .(NASDAQ:CIEN), JDS Uniphase Corp. (JDSU), Corning, Inc. and Ariba Inc. (NASDAQ:ARBA). Now the theme is social media and web-based companies, like Netflix, Inc. (NASDAQ:NFLX), Open Table Inc. (NASDAQ:OPEN), and LinkedIn Corp. (LNKD). Momentum investing can be very rewarding as long as it lasts. But it can result in hefty losses once it fades away, usually when liquidity dries up.

  3. Stay away from U.S. Treasuries -- and Treasury ETFs like TLT. Though U.S. Treasuries are the first investment to come in mind when the economy heads into recession. This time yields are already near record low levels, so any gains from here will be limited.

  4. Buy an ETF that is short on U.S. Treasuries like the ProShares UltraShort Lehman 20+ (NYSEARCA:TBT) or ProShares UltraShort Lehman 7-10 (NYSEARCA:PST). The problem for investors, however, is that both funds bet against the daily price movements of U.S. Treasuries, and therefore, they do not make good long-term bets.

  5. Buy Portfolio Protection, using puts on SDR S&P 500 (NYSEARCA:SPY) or calls on iPath S&P 500 VIX ST Futures (NYSEARCA:VXX).

A few words of caution: While a Fed exit is eventually imminent, it cannot be timed. That's why investors should place these bets gradually rather at once, monitoring closely the indicators that may prompt the Fed to move in this direction like the unemployment rate.

Disclosure: I am short NFLX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Long FCX, TBT.