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Last week, I warned you about the unique and unprecedented convergence of three crises in one time and place — a severe U.S. recession, surging inflation, and close encounters with a Wall Street meltdown.
Now, just seven days later, news on each of these crises has burst onto the scene with gale force, wiping away the last vestiges of sugar-coating by Pollyanna analysts … creating the conditions for a bond market disaster … and driving the U.S. stock market into a tailspin:
- Deepening the U.S. recession, vehicle sales are expected to plunge to 15-year lows. Dealer lots are overflowing with gas-guzzling trucks and SUVs. But they can’t get their hands on enough fuel-efficient cars, limiting sales in the most popular models. Another warning sign: S&P has just put GM, Ford and Chrysler on “credit watch negative.” End result: Don’t be surprised if one of the Big Three — Ford, GM or Chrysler — is soon forced to file for bankruptcy.
- Bankruptcy has already struck over 20 airlines worldwide, with many more on the way. In the U.S alone, the top 10 U.S. airlines are expected to post pre-tax losses of nearly $18 billion this year and next. At the same time …
- U.S. inflation is surging. In May, producer prices jumped 7.2% compared to a year earlier; import prices catapulted 17.8%, the biggest rise ever recorded; and even the so-called “core” producer prices (excluding food and energy) rose at the fastest pace since 1991! Adding to this explosive mix …
- The bond insurance disaster I’ve been writing about for many months has finally struck: In one fell swoop, Moody’s has downgraded MBIA’s ratings by five notches and Ambac’s by three. In turn, this is threatening the finances of hundreds of thousands of states and local governments that are covered by these two giants of the industry.
The entire bond insurance system — whereby issuers of municipal bonds and mortgage bonds could effectively “buy” a higher rating simply by taking out some insurance — has always been questionable. Now it’s a house of cards, and it’s crumbling. Result: Another wave of bank losses and write-downs that could exceed the losses from the housing and mortgage crisis.
- All of this is bound to drive most U.S. stock sectors — especially financial stocks — into the gutter. Already, the benchmark banking sector index (BKX) is about to bust below the low set in 2003, during the depths of the last bear market. Expect the same for other sectors as well.
What to do? Last week, I also gave you very specific recommendations on where and how to build your first defense.
Next, if you haven’t done so already …
Urgently Consider the Following Steps to Build
A Defensive Wall Around Your Stock Portfolio
In the past, if you wanted protection against falling stock prices, you had to sell short. Or you had to use futures markets. And in either case, you could expose yourself to unlimited risk.
Today, fortunately, you can take advantage of a simpler, risk-controlled defensive strategy.
The vehicle: Inverse ETFs — special ETFs designed to go up when a particular stock index or sector goes down.
The good news: You can buy these inverse ETFs just like any other ETF — through your same broker, with the same low commissions and the same flexibility to get in and out as you please.
More good news: You can buy single-leveraged ETFs, designed to go up 10% for every 10% decline in the index. Or you can buy double-leveraged ETFs, designed to go up 20% for every 10% decline.
The best news: A whole new series of inverse ETFs are now available that you can use for protection against declines in specific industry sectors — real estate, financials, consumer goods, semiconductors, technology and even emerging markets.
This allows you to match your hedges more closely to the sectors or styles you’re heavily concentrated in. For example …
- If you have a lot of technology stocks, you could use the inverse ETF with the symbol REW.
- If you have a lot of small-cap stocks, you could use the SDD inverse ETF.
- If you have a broadly diversified domestic portfolio, you could use DOG or DXD, which move inversely to the Dow Jones Industrial Average … or SH, SDS or RSW, which move inversely to the S&P 500 Index.
- If you’re heavy into emerging markets, you could use EUM or EEV.
This morning, I’ll guide you to additional information on each of these, plus many more. But first, here are the steps I recommend:
Step 1. Determine how much money you want to set aside for portfolio protection. To help you think that through, let me first show you what the different possibilities are, and then I’ll tell you which ones I prefer.
Possibility A. Let’s say you have a $100,000 stock or ETF portfolio that is broadly diversified and approximately matches the performance of S&P 500. And let’s say you want to protect the entire amount using an inverse ETF that’s single leveraged — designed to go up 10% for every 10% decline in the S&P 500.
Problem: That could be very costly. For every dollar in your portfolio, you’d have to invest another dollar in the inverse ETF. And to do that, you’d have to come up with another $100,000 from some other source to throw into the game.
If you were in Las Vegas, that would be tantamount to betting $100,000 on red … and then finding another $100,000 to bet on black. You may think you can’t lose. But the reality is you can’t win either: You’re incurring costs or commissions, and no portfolio protection is perfect. So even in the unlikely event of a “double-zero” doomsday scenario, you could wind up losing something on both red and black.
Possibility B. Instead of full protection, why not settle for half protection? In other words, for every $1 of current value in your portfolio, you’d put up only 50 cents of your money into the inverse ETFs. Assuming a stock portfolio worth $100,000, that would mean investing another $50,000.
Possibility C. Use an inverse ETF that gives you double leverage. Now, to protect half of your $100,000 portfolio, all you’d need to invest is $25,000. Assuming your portfolio falls 10% in value, here’s what you’d have:
End result: A $10,000 loss in your stock portfolio and a $5,000 gain in your hedge portfolio, for a $5,000 loss overall. That cuts your risk of loss in half. Not bad.
But you ask: Can’t we do better than that? The answer: Yes, as you’ll see with the following steps …
Step 2. Rather than invest new money in the inverse ETFs, raise that money by liquidating one-third of your stocks. Then, here’s what you should wind up with:
You’ll have $66,667 left in your portfolio, and $33,333 available to invest in an inverse ETF with double leverage.
If the market falls 10%, you’ll have about a $6,667 loss in your portfolio and about a $6,667 gain in your inverse ETF. End result: No loss (except for commissions and costs).
This simple step brings you two advantages: First, you won’t have to dig into your cash assets to fund your hedge strategy. And second, you’ll get close to full protection for the balance of your portfolio.
Again, the reason I stress the word “close” is because no portfolio protection can be perfect. You’ll still have to pay commissions and some costs. And the double-leveraged inverse ETFs may not always deliver exactly the full double leverage they’re designed to provide.
You could stop there and you’d have achieved your goal of risk protection. But if you want to apply some additional intelligence (with some additional risk), you could do even better by following a couple of advanced steps …
Step 3 (advanced). Instead of liquidating one-third of your stocks randomly, strictly get rid of the ones that are in the riskiest sectors, while holding on to those that are in the strongest sectors. In our regular publications, we tell you which ones we believe they are. But let’s assume we’re only half right and we get the following results:
- Overall market: Down 10%
- Weakest sectors: Down 20%
- Strongest sectors: Down 5%
In this scenario, we’re half right in the sense that the strongest sectors outperform. But we’re also half wrong, because instead of rising as we expected, they still go down, albeit not as sharply. I think that’s a reasonable expectation. But even in this situation, you wind up a winner:
Since your portfolio is strictly in the strongest sectors, your loss is reduced from 10% to 5%, or only $3,333. Meanwhile, you’re still gaining 10% on your hedges, or $6,667. End result: Despite the market’s overall decline of 10%, you actually come out ahead.
Step 4 (more advanced). Assume the same scenario as the previous example. And assume the same steps to liquidate the riskiest sectors while holding the strongest. But in addition, instead of using strictly an inverse ETF that matches the S&P 500, use inverse ETFs that are designed to make you money when specific sectors are going down, targeting those that we believe to be the weakest.
Again, there’s no guarantee that we’re going to be right. But assuming we’re half way right (as in Step #3), here’s how it would turn out:
You’d still have a $3,333 loss in your stock portfolio. But on the other side of your portfolio — the inverse ETFS — the bad sectors fall 20%. So your double-leveraged ETFs give you a gain of 40%, or $13,333 (minus commissions and costs, of course).
Your net gain overall: $10,000!
End result: You’ve just turned what could have been a $10,000 loss in your portfolio into a $10,000 gain instead. That’s what I call turning lemons into lemonade.
Your Next Steps
Fortunately, virtually all of the ETFs you’ll need for this program are now available for purchase. And to help you find the ones that best match your portfolio, my team has compiled a complete and current listing for you.
Here’s what to do:
1. Use our accompanying spreadsheet, “The Money and Markets Guide to Inverse ETFs.” Click here to download the table as a pdf. Or click here to download it as an Excel spreadsheet.
2. Search in alphabetical order for the indexes or sectors that you would like to use as hedges, based on my instructions above.
3. In the next column, find the names of the inverse ETFs that match those indexes.
4. In the “leverage” column, please note most are double-leveraged inverse ETFs, which is what we recommend for this strategy. But some single-leveraged inverse ETFs are also available.
5. For the latest chart of these ETFs, enter the symbol at Yahoo! Finance, www.BigCharts.com, or your favorite Web charting program.
6. And for further information from the provider of each ETF, just click on the name of the ETF in the spreadsheet to view its web page. Or visit …
Profunds at http://www.proshares.com/funds and
Rydex at http://www.rydexfunds.com/etfcenter/home/etf_profiles.rails
Be sure to act swiftly before you suffer further significant damage to your stock portfolio.
Good luck and God bless!
Martin
About Money and Markets
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Money and Markets (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Tony Sagami, Nilus Mattive, Sean Brodrick, Larry Edelson, Michael Larson and Jack Crooks. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates
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