7/27/2011 3:26 PM ET|
Save yourself from US debt disaster
Politicians say they're committed to making sure the US doesn't default on its debt, but their actions haven't inspired much confidence. Here's how investors can prepare for the worst.
We're into the third year of the economic recovery, and stocks are stuck again. The Standard & Poor's 500 Index ($INX) is trading at levels it reached in February; it's been skidding sideways since.
The past five months have brought a series of potential financial disasters. We've seen Arab revolutions, Japanese calamities, a Portuguese bailout, a second Greek bailout, $115 oil, $1,600 gold, and no fewer than two round-trip stock sell-offs of more than 7%.
And now, there's the U.S. debt-ceiling mess -- which is really two issues snarled into a rat's nest of competing ideologies and hard choices. There is the long-term federal deficit/debt problem. And there is the short-term problem of raising the Treasury's borrowing limit by Aug. 2. Failure to do the latter would set off a chain reaction that might have the U.S. defaulting on its debt.
Last week, in "Debt cure is going to hurt," I looked at the likelihood that a deal will lead to years of inflation designed to shrink the nation's debt, similar to strategies used in the past. So far this week, a deal remains elusive, and the probability of default has gone from "no way" to at least possible.
So it's time to look at ways to protect your portfolio from a debt deadlock -- without losing a lot if Congress and the White House manage to do the right thing after all.
The doomsday scenario
Of course, everyone in Washington still swears they want to avoid a U.S. debt default, because the alternative is so dire. Inaction could also shut down parts of the government and lead to a credit downgrade for the U.S.
And all this could also mean a repeat of the kind of panic seen the last time we faced a big financial policy crisis and made poor choices. That, of course, was in late 2008 after House Republicans initially torpedoed a bank bailout and the Bush administration let Lehman Brothers collapse. Congress eventually OK'd a bailout, but the mishandling of that crisis is part of what made the Great Recession so painful.
For investors, the fallout was severe. From the time the extent of the financial mess became clear in late 2008 through the bottom of March 2009, the market lost roughly half its value. Our 401ks and IRAs crumbled. Yes, the market has made most of that back, but we're still struggling with 9%-plus unemployment and halting growth. Trust me, we don't want to go through something like that again. Not with the economy already vulnerable.
But where there was once promise of bipartisan compromise and a $4 trillion budget deal worked out by President Barack Obama and House Speaker John Boehner, R-Ohio, we now see political squabbling and a hardening of positions. Investors are understandably nervous that Washington is playing political games with our fragile economy.
Can the Democrats and Republicans come together to tackle the deficit and raise the debt ceiling, current bluster aside? No one really knows. And that's what makes the situation so scary. We're flying in the dark here.
Preparing for the worst
So what can the average investor do to prepare for the doomsday?
Getting ready is not impossible, but it means using the right strategy in a market where volatility is high and diversification offers less and less protection from market ups and downs. It's about finding new ways to protect your wealth.
That's no longer as simple as moving from stocks to cash, or buying gold. Cash holdings will be slowly eroded by low interest rates and higher inflation, while gold is vulnerable to swings in the dollar and is extremely sensitive to policy outcomes. There also appear to be signs of froth in the gold market -- it might already have gone too high. And as I discussed last week, bonds, another usual refuge, seem ready for a multidecade period of underperformance relative to stocks.
What you need to do, then, is stay focused on the strongest stocks rather than just hiding, while avoiding the weakest and reducing your overall exposure to the market. Here's how I'd go about it.
First, take control
There's no denying that this is a difficult environment. Volatility is on the rise, which makes trading a harrowing task for even the most grizzled veteran. But correlations are also on the rise, which means that different assets -- precious metals, stocks, corporate bonds, commodities, crude oil -- are increasingly rising and falling together.
So not only does the market feel more dangerous, it's harder for investors to diversify, relying on a wide variety of investments to smooth out the ups and down in their portfolios.
The chart above shows how crude oil futures and the S&P 100 Large Cap Index have been moving in lockstep over the past three years. Before, they moved to their own drumbeat. (The way the chart works, the higher the correlation number, the more oil and stocks are moving together.) When that happens, there is no diversification benefit to be had by holding both in a portfolio. The team at Credit Suisse notes that it's the same story with U.S. stocks versus foreign equities and stocks versus commodities.
This combination of unpredictable political risk, increased volatility and tighter correlations across asset classes is a toxic one.
We have a situation with two possible outcomes: We default and get a downgrade (and everything falls apart) or we get the budget under control and raise the debt ceiling (and the specter of default passes, with stocks and other risky assets blasting higher). There really isn't a middle ground. And with all those assets moving together, you can't hedge your bets.
A great example of this can be seen in the way silver imploded in May, after the U.S. dollar spiked after the killing of Osama bin Laden. Suddenly, it felt like America had gotten its mojo back. Global financial markets responded by sending the dollar higher, ending a four-month downtrend.
For most of us, it was all good. Bin Laden was dead. We felt a surge of pride and patriotism. Gas prices dropped. And inflationary pressures cooled, thanks to a stronger dollar.
But because the dollar has a close relationship with risky assets, Wall Street panicked. Silver and gold fell first -- followed by crude oil and a long list of other commodities, including industrial metals and copper. Then foreign stocks. U.S. equities came under pressure in June. And finally, corporate bonds suffered a dramatic sell-off on June 16 that marked the end of the drop.
So you can see, there was no place to hide. The selling pressure unleashed by currency fluctuations spread through the system like wildfire. Diversified or not, people got burned.
No more buy and pray
My point is this: The investing environment has changed. Decades ago, when correlations were lower and diversification more powerful, buying and holding a range of investments was the way to go. It paid off over time. And this is still how a lot of people run their retirement investments -- buy and hold, or even buy and forget.
But the advent of a more integrated global financial system has reduced the protection offered by owning bonds and dabbling in commodities along with owning stocks. Just when people need protection, it's harder to find in the traditional places.
The intriguing news is that while correlations are on the rise among asset classes, we're seeing a drop in correlations within the stock market. Simply put, certain areas of the market still outperform other areas on a regular basis. As a result, investors can diversify by regularly moving into areas of the market showing strength and leaving those showing weakness.
In other words, investors need to refocus on good old-fashioned stock selection -- especially in an environment of extreme political and economic uncertainty.
That's because it offers the best result no matter what Washington does on the debt ceiling: If Obama and the Republicans do the right thing, the strong stocks will lead the way; if they don't, strong stocks will fall the least and give you time to get out.
Green means go
They key is focusing on the sectors showing strength. At the same time, by focusing on where the action is and shedding underperformers, you can reduce your overall stock holdings while keeping pace with benchmarks like the S&P 500. Because you're not putting capital into underperforming sectors, you can maintain a larger cash reserve without missing out if the market takes off.
Easier said than done, right?
To help you along, I want to share one of the tools I created for the benefit of my newsletter subscribers: A collection of charts showing the performance of major sectors versus the broad market. You can access it for free at stockcharts.com.
Here's one chart, tracking energy against the S&P 500:
The setup is a bit technical, but the display style makes it simple to see strength and weakness. You invest in sectors only when they are demonstrating outperformance via the following conditions:
- The price bars (shown above in green, blue or red) are green.
- The price is above the nine- and 18-day moving averages.
- The nine-day average is above the 18-day average.
- The MACD indicator in the lower pane is above the zero line and rising.
I also like to focus on sectors where relative price is pushing on the upper Bollinger band (which is the shaded gray area). The chart above illustrates how the energy sector is on a buy signal right now, as it meets all the conditions. A buy signal was triggered in the first week of July.
Based on these criteria, the tool would have investors focused on energy and technology stocks this month while avoiding transportation, health care and industrials. Here's the month-to-date performance of these sectors, represented by exchange-traded funds:
- Energy Select Sector SPDR (XLE): 5.3%
- Technology Select Sector SPDR (XLK): 4.3%
- Health Care Select Sector SPDR (XLV): -1.4%
- iShares Dow Jones Transportation (IYT, news): -2%
- Industrial Select Sector SPDR (XLI): -2.8%
For reference, the S&P 500 was up 1.1% over this period.
Using this strategy has helped the Edge Portfolio (which I maintain for my subscribers) post a 14% gain over the past three months versus a 2% loss for the S&P 500. It works.
Advanced investors and traders can take the strategy one step further by scouring for the strongest stocks within the strongest sectors. In energy, two examples I've recommended to my newsletter subscribers are SandRidge Energy (SD, news) and Hyperdynamics (HDY, news), which are up more than 9% and more than 23%, respectively, since adding them to the portfolio earlier this month.
Hyperdynamics is also being tracked in real time hereas part of my sample portfolio for MSN Money readers.
Summing it up
There are three takeaways here. The first is that the market is becoming a dangerous place, with higher volatility, political uncertainty and more extreme potential outcomes. The second is that the usual safe havens like bonds and gold aren't as safe as they might seem. The third is that a strategy of narrowing your focus to the strong areas of the stock market seems like the solution.
Yes, it will be more work than holding on. We won't be able to let our 401ks and individual retirement accounts sit still. But I think the rewards will justify the effort, especially in these uncertain times.
Even if the debt ceiling ignites another panic, carrying a cushion into the event, courtesy of the gains in tech and energy, gives us the luxury of staying invested -- and preparing for the epic market rally that should follow an eventual political compromise, even if it comes at the last minute.
At the time of publication, Anthony Mirhaydari owned or controlled shares of Hyperdynamics. He has recommended Hyperdynamics and SandRidge Energy to his newsletter subscribers.
Be sure to check out Anthony's new money management service, Mirhaydari Capital Management, and his investment newsletter, the Edge. A free, two-week trial subscription to the newsletter has been extended to MSN Money readers. Click here to sign up. Mirhaydari can be contacted at email@example.com and followed on Twitter at @EdgeLetter. You can view his current stock picks here. Feel free to comment below.
VIDEO ON MSN MONEY
And now they just took this one down. The truth is out there no matter how hard you may want to hide it.
This is just one example of way too many to list. For twenty years General Electric was under contract to operate the Hanford Nuclear facility, and was paid well by the taxpayer to do this work. GE left behind a nuclear toxic legacy that is mind blowing in its scope. Now who is paying for this forever cleanup that will total unknown billions to cleanup? That would be the taxpayer. Today GE pays zero dollars in corporate taxes, and receives $5 billion a year in taxpayer subsidies. Of course this government policy is designed to encourage corporate job creation which is a myth that will never materialize as evidenced by this betrayal to the nation and the American people. Yesterday GE announced that it is moving its Waukesha, WI based X-Ray division to China. Yes sir, indeed. There is your job creation; it’s just in China as usual. Now why should I support tired backwards policies that smack of treason? Thank you GE, and thank you United States Government.
Second. Now he states that it's the governments fault for how it handled the crash of 2008, and that it should have bailed out the system faster. I still can't figure out how such a great system that represents the bastion of Capitalism, is the stalwart of free enterprise, is on the up and up of honesty and integrity is in need of a bailout every 20 years, and crashes like the clock work of a cheap watch every 7 years. Maybe, just maybe there is something wrong with the system itself as in greed that over inflates every dollar into a million Voodoo dollars, and then spends it right away before anyone is the wiser. Maybe there is something wrong in a system that will destroy a perfectly good company just because it didn't make a record quarterly profit, so now it's time to slash and burn it after selling off it's assets to make a quick dishonest buck. How long will it take for Wall Street to re-learn basic Economics 101, and that is, the more employees that a nation has equals the more consumers that a nation has, equals the more investors that a nation has, equals more growth. But then again that makes too much sense, and of course most people these days will not invest in a system that specializes in the looting of honest investments.
I am an American Electrical Engineer working overseas and I read your comments with interest. As part of my job, at the company that I work with, I specify millions of dollars worth of Electrical Equipment in which GE supplies as one of the competitors in the arena. After reading your Blog, (about GE outsourcing their Wisconsin operations to China), bet your bottom dollar that I will NOT consider GE equipment for my projects, and will convince my Management to do the same. Furthermore, I might buy a small amount of GE stock to allow me to protest at the next GE shareholder meeting about their tax writeoffs and outsourcing. Hope more people will do the same.
As a former Product Line Manager in manufacturing, I fought for years to use domestic vendors for parts and production, but watched it all get moved to China. I always reminded my colleagues how much we were screwing ourselves with late deliveries, customs hold-ups, bad quality, and downright dishonesty from the Chinese. We always ended up with more cost and more problems long-term. But, when you have a quarter to hit and want your bonus, well it looks good on paper short-term.
I was told I was naive and that this was how things were going to be. I watched hundreds of domestic vendors go out of business, not to mention thousands of layoffs, all the while hearing from the CEO's that taxes were too high, even when the wrote their losses off, and paid little tax at all.
Then, after killing jobs and my company, the executives took a few millions in severance and left.
So called default is a minor thing. The real problem is INFLATION, stop inflation and people will take care of other problems. Big brother in Washington is telling everyone how to run their life.
Talk the last few days about Norway, there is another side to the story. I worked there one summer on a job with many engineers, the young well educated people wanted out of Norway. Young people wanted help getting out, I helped three young people move to the US, and they have done great in America. Their problem in Norway was, tax took everything young people made. Life for most people was not all that sweet. Ever story has two sides
. America is a great county, nothing else in this world like it. Try to keep it free of Washington..
I want to get back into the market, but now is too volatile for me to handle. So I'll try to sit on my cash for a bit until the little brats in government can play nice again. Either that or retire to Mexico.
What I don't understand is why doesn't the govt eliminate "stuff" that is available to people who don't deserve it....such as why are prisoners getting free health and dental care.....without having to wait 6 hrs to be seen. Why do they get to even have a plasma TV to watch in prison, when I can't even afford one for myself. Why do they get to have sandwiches, with fruit, and chicken, steak, potatoes for dinner when many families can't even afford to eat that!
What happen to the good old days when prisoners cleaned up and were force to do labor to contribute back to society? Get rid of the gyms and weights in the prison yards, go out and pick up garbage, clean and trim the weeds off the highways, do something!
Why is there people on welfare for years.....there should be a limit. And if you some young girl that had a kid at 16, and i understand you need welfare and WIC, but you still manage to get pregnant and are now 23 with 5 kids....that is a problem! Sorry but U should lose your reproductive rights! Especially in this country with so many forms of birth control, there is no excuse! And to allow women/men to milk this country and people who do work, shame on you!
Where is the equal treatment? Cause I work, I pay my taxes, I am a contributing member of society, yet I have no health nor dental. And if I wanted some, I would have to wait 6 hrs at Highland hospital (Alameda county hospital) just to be seen. I don't own a flat nor plasma nor LED TV but yet the prisoners have one. Yes, I can afford to have sandwiches, steak and potatoes, but that is because I WORK MY **** OFF!
Plus, as American people we need to change our lifestyle, we need to be more resourceful....we can't complain about not having jobs when we want things so cheap.....so no wonder companies go to China, and else where. Cause trust me....the minute HS drop outs would be force to pick our fruits and veggies, the prices will go up.
i am really beginning to think the safest place for whatever small amount of $$$ i have been able to put aside is in my mattress. protected of course by SMITH & WESSON!
the idiots in washington on both sides of the aisle have got to start thinking about why they are in office in the first place. they are there SUPPOSEDLY to protect the interests of ALL americans so they need to stop thinking and acting along party lines and get this mess straightened out. this country is going to hell in a handbasket because of the POLITICS being played in washington. social security is NOT an entitlement, it was paid into by working americans since its inception and was raided to pay the governments bill and given IOU's in place of cash. WHY does that NOT give me a warm fuzzy feeling? the TAX INCREASES boner (misspelled on purpose) is conecrned about are not increases but LETTING THE TAX CUTS set in place by the wonderful G.W.B. to protect his cronies expire!
ENOUGH WITH SUBSIDIES TO OIL COMPANIES, BIG BUSINESS, AIRLINES ETC...they get money to help them out but increase prices to the consumer anyway. think it's about time for the little guy to get a subsidy!
I believe that the political thugs on both side of the aisle should be given a jolt when the next election comes along. I doubt any of them have a clue about the economy.
Just saw the profit of the oil companies and new job analysis. We need to get rid of the outsourcing and free trade agreements and remove the tax breaks for Oil companies and their ilk and put in laws for price controls and War Profiteering fines and long jail terms.
These are not new ideas. They were done in WWII and we are in two or three wars now.
Leave Social Security alone, except remove the unfair "notch baby law" and leave Medicare alone. We pay for both.
Again, hopefully those less than mediocre politicians will not only lose their pensions, expense accts, medical benefits and have their salaries reduced and then be removed from office.
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[BRIEFING.COM] The major averages continue to hover near their flat lines as investors await the afternoon statement from the Federal Open Market Committee.
Notably, health care, utilities, and telecom services continue to hover near their lows. Similarly, financials and industrials remain in the red while other cyclical sectors alternate between gains and losses.
In the Treasury market, the 10-yr note is on its lows with its yield higher by one basis point at 2.203%. ... More
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