A 2014 Correction Survival Guide: 3 Trades To Make

by: Charles Lewis Sizemore, CFA

After a fantastic 2013, the new year is getting off to a slow start. The first three trading days saw the S&P 500 in the red, and, at time of writing, it looks to be five out of the first seven.

I expect 2014 to be a good year for investors, and particularly those investors intrepid enough to invest in Europe and emerging markets, where I see the best values. But I also believe it's likely that we get at least a mild correction in the first quarter. It's been nearly 29 months since the last correction of 10% or more, and while this does not necessarily mean we are "due" for a correction (for example, the market enjoyed an 81-month correction-free run in the 1990s), it doesn't hurt to be prepared.

I should repeat that I do not -read NOT- expect a major crash or bear market in 2014. The news that the market has been dreading for months-that the Fed would begin to taper its QE Infinity bond-buying program- has already been absorbed, and the other three major sources of investor concern- the ongoing eurozone malaise, China's cooling economy, and partisan paralysis in Washington- are all showing signs of improvement. Nevertheless, a 10%-15% correction can come always out of the blue. And today, I'm going to offer a correction survival guide with three ways to prepare yourself…just in case one does.

Buy Bonds

Bonds? Seriously? Yes. I realize fully that bonds are the most hated asset class in the world right now. As in totally despised. And that is precisely what makes them a good hedge at the moment.

There is a general and widespread belief that the Fed's tapering plans automatically mean higher bond yields. All else equal, it would. But in the world of investments, "all else equal" conditions rarely hold. As I wrote in December, demand for U.S. bonds from foreign institutional investors has recently been at its highest levels since 2000. And at the same time, the growth rate in the supply of new Treasuries has been dramatically slowing due to the shrinking of the U.S. budget deficit.

But more fundamentally, it is difficult for me to see bond yields rising significantly in a prolonged period of low inflation. The U.S. economy does indeed appear to be growing again at a decent (though far from spectacular) clip. But that growth has not come at the cost of inflation, which is still limping along at a 1.2% rate. And I expect to see inflation stay muted for a long time due to lower energy prices- a product of the domestic energy revolution- and slower debt accumulation due to the pending retirement of the baby boomers.

As I'm writing this article, the yield on the 10-year Treasury is a hair shy of 3%. That is not a high enough yield for me to consider bonds a good investment. But at these yields, I do see bonds as a great hedge. And I'm not alone. Jeff Gundlach- considered by many to be the sharpest fixed-income manager in the business-commented in a recent Barron's interview that he could see yields falling to new all-time lows. That may be too extreme; only time will tell. But in my view, the "correct" bond yield given the lack of inflation and the overall hunger for yield from retiring boomers is somewhere in the ballpark of 2.5%.

Invest In Dividend Paying Stocks

As another hedging option, you might consider rebalancing the equity portion of your portfolio away from growth and into lower-beta dividend paying stocks. This is an imperfect hedge -in a broad-based market correction, nearly all sectors take a hit- but as an old finance professor of mine used to say, "the only perfect hedge is in an English garden."

Within the dividend-paying universe, I'm particularly attracted to triple-net REITs. Investors feared the absolute worst when the Fed first started to really make noise about tapering in May of last year, and they dumped virtually all securities for which income is a major component of returns. In the process, they left us with some real bargains.

As I wrote last month, REITs such as American Capital Realty Properties (ARCP) now yield an impressive 7.5%-and this from a conservative property portfolio leased out to a diverse, high-quality tenant base. A REIT like ARCP would be a great bargain even if the worst fears about tapering proved to be true. And if tapering proves to be a non-factor, as I expect, then ARCP is an absolute steal. In a broad-based market selloff, ARCP and its peers among triple-net retail REITs would probably fall too. But given the beating the stock has already taken -it's down nearly 30% from its May highs- it would be falling from far less lofty levels.

Buy Puts or Sell Calls

This is the truest hedge of the three investment options I've laid out.

Buying a put is the closet equivalent to actual portfolio insurance you will ever find. In an insurance arrangement- be it home, auto, health, or life- you pay regular premiums. The insurance policy is an expense that cost you money- unless a catastrophic event happens, and the policy pays off. The logic behind a put is the same. If you buy an out-of-the-money put on the S&P 500 and the market rises or trades sideways, then your option expires worthless- the same way that fire insurance is "worthless" unless your house burns down. But if the market falls below the strike price of the option, the option pays off.

If puts are such a great insurance policy, then why doesn't everyone use them? The answer is simple: they are expensive. As an example, a put option to sell the SPDR S&P 500 ETF on or before February 7 for $180 per share (slightly below the current price) will cost you $1.19. That's just fine if you really believe a sell-off is coming. But if not, it's throwing money down the drain.

But if you think any correction is likely to be mild, there is an alternative. You can sell a covered call option. In a covered call, you sell the option to buy a stock you currently own to another investor and pocket the premium. If the option expires worthless, then the premium is yours to keep as income. The downside? If the value of the underlying stock rises, then you will be forced to sell your stock at below-market rates. Of course, you would always be free to buy it back later.

Options trading is not for everyone. Of the three hedging options I mentioned, options are the riskiest for the uninitiated. If you decide to go this route, you should probably have your broker or financial advisor walk you through it the first few times.

Disclaimer: This site is for informational purposes only and should not be considered specific investment advice or as a solicitation to buy or sell any securities. Sizemore Capital personnel and clients will often have an interest in the securities mentioned. There is risk in any investment in traded securities, and all Sizemore Capital investment strategies have the possibility of loss. Past performance is no guarantee of future results.

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