After a fantastic 2013, the new year is getting off to a slow start. The first few 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 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% to 15% correction can come always out of the blue. And today, I’m going to offer five ways to prepare yourself … just in case one does.
#1: Buy Bonds
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 might 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%.
#2: Invest in Dividend Stocks
As another hedging option, you might consider rebalancing the equity portion of your portfolio away from growth and into lower-beta dividend 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 offer stunning yields, including ARCP at 7.3% — and this from a conservative property portfolio leased out to a diverse, high-quality tenant base. A REIT like American Capital would be a great bargain even if the worst fears about tapering proved to be true. And if tapering proves to be a nonfactor (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.
#3: Overweight International Stocks
This recommendation, like investing in dividend stocks, is not exactly a perfect hedge. In addition to regular equity risk — beta, if you will — you also introduce currency risk into the mix.
Still, I’m OK with this for two reasons.
First, there is valuation. As I wrote recently, overseas markets are, for the most part, significantly cheaper than the American market. As measured by the cyclically adjusted price/earnings ratio (or CAPE), the United States is the second-most expensive market in the world today, second only to Sri Lanka of all places. Now, to be fair, the U.S. market probably deserves a premium valuation over the rest of the world given its high reporting standards and its liquidity and breadth. but it shouldn’t be nearly double the level of the U.K. or France, which is where it is today. The U.S., U.K. and France sport CAPEs of 25.44, 13.61 and 14.04, respectively.
Diversification is important too. Even without the yawning valuation gap, investors should keep a decent-sized chunk of their portfolio in nob-U.S. assets. We live in a global economy, and U.S. stocks only make up about a third of global market cap.
One reason that U.S. stocks outperformed last year was a belief that the U.S. economy was the “cleanest dirty shirt.” Growth here wasn’t great, but it looked better than Europe and most emerging markets. While these conditions are still true, it’s hard to believe that they are not already priced in. Meanwhile, Europe and emerging markets beckon …
#4: Buy Puts or Sell Calls
This is the truest hedge of the 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 costs 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 (SPY) on or before Feb. 7 for $180 per share (slightly below the current price) will cost you $1.19 (so, $119 for a contract for 100 shares). That’s just fine if you really believe a selloff 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, the premium is yours to keep as income.
The downside? If the value of the underlying stock rises, 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 hedging options I’ve mentioned, options are the riskiest for the uninitiated. If you decide to go this route, you probably should have your broker or financial adviser walk you through it the first few times.
#5: Don’t Trust Gold
One last move you’ll want to make to protect yourself is to avoid a particular asset — specifically, don’t buy gold.
Yes, I know the line: “Gold is the one true source of value and the only currency that has withstood the test of time.”
Sure, that sounds good, but it doesn’t square with reality. Gold is a traded commodity; nothing more, nothing less. And the price of gold, like any other commodity, fluctuates with supply and demand.
Well, the factors driving demand for gold in recent years are all in reverse at the moment. As I recently wrote for InvestorPlace, the inflation that everyone seemed to fear would spring from the Fed’s quantitative easing never happened. The most recent CPI reading showed inflation at 1.2%, and energy prices — which rose throughout the 2000s — continue to sag due to the recent flooding of the market with cheap American shale oil and gas.
Quantitative easing is getting tapered, the federal budget deficit is actually shrinking, and the hedge funds and ETFs that were so instrumental in driving gold demand are now seeing outflows. Meanwhile, supply from the world’s mines remains high (at least for now), as production was ramped up during the boom years.
High supply and sagging demand is a recipe for falling gold prices. If you’re a trader, feel free to speculate in gold, long or short. But if you’re an investor looking to hedge, look elsewhere.
Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management. As of this writing, he was long ARCP. Check out his new premium service, Macro Trend Investor, which includes a free copy of his e-book, The New Megatrend Investor: The Ultimate Buy-and-Hold Strategy That Will Make You Rich.