Submitted by Covestor Ltd. as part of our contributors program.
Author: Bill DeShurko, 401 Advisor
Covestor model: Dividend and Income Plus
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Disclosure: Long MCD, PPL, JNK, SH, GDX
Investing is an art that deals with probabilities, not with certainties. And as negative possibilities loom in Europe, the only prudent course of action is to take steps to protect your portfolio.
There is no easy fix for the Eurozone crisis. Angela Merkel has steadfastly said that Germany will not agree to yet another major bailout unless the recipients agree to fiscal reform and give up control over budget policy to either Germany or some other EU sponsored body.
The idea of giving up sovereignty has been met with a “drop dead” response from many crisis countries. However, over the past weekend the rumors have been flying that a grand plan is in fact taking shape.
My point is that no one knows what will happen in Europe. It is possible that the situation in Europe could spin out of control and produce another “Lehman moment” in the near future.
Under that kind of scenario, investors could see portfolio values drop by as much as 50% – which is what it would take to bring the market back back down to its post-Lehman low back in March of 2009.
I have taken several defensive steps, based on our different portfolios’ overall strategies. At the same time I am watching out for “buy” signals should the market turn on positive news. Yet the overall stance is defensive. I believe the probability is high that Europe begins to fall apart thanks to the problems in Greece and other highly indebted countries.
First, I did a screen looking for stocks with a 3% or higher yield, beta (an indicator of volatility with 1 being equal to the market) of less than 1, and a P/E of less than 15. From this list, I replaced our higher yielding, but higher beta holdings, with stocks like McDonalds (MCD), and PPL Corporation (PPL).
Next, I looked at the hedging strategy. I typically hold 20% of our Covestor portfolio in JNK, the Spider High Yield Bond ETF. I will look to sell JNK when it crosses below its 30-day moving average. (It did just that recently and we sold.)
Normally I’m happy sitting in cash. Not this time. Instead I allocated the 20% of the portfolio to (SH), the ProShares short S&P 500. This is not a leveraged ETF, the daily return corresponds to the opposite of the daily return on the S&P 500.
Finally, we are holding a 5% cash position.
This positioning allows me to minimize our losses if the market continues down, and still generate cash flow from dividends to either reinvest or pay out. At the same time we (hopefully) will experience a net gain in an up market. In addition, it is an easy trade to sell our short and repurchase JNK, for both yield and capital appreciation if market sentiment turns around.
I also manage a growth-oriented portfolio utilizing exchange traded funds. As with our dividend portfolio mentioned above, I rotated to lower beta ETF’s in early April. I recently rotated from holding the SPDR Gold Trust (GLD) ETF to (GDX), the Market Vectors gold miner’s index.
This has been a good trade, given the support for gold around $1500 an ounce. With this strategy, I will stay in lower beta holdings until fall, October or November. But I will also sell and go all cash if the market drops below, and stays below the 200-day moving average.
Two other points: Since most 401(k) plans are invested in mutual funds that limit trading, we are still long. However, as with our growth strategies, we will start going to cash on the 200 simple moving average crossover of (SPY), the S&P 500 index ETF.
Our utility holdings is the only sector strategy where we are 100% long, and plan to stay that way. Utilities have held up very well through the turmoil. I plan on holding and collecting our dividends through thick and thin.
To sum up, here is my strategy for the uncertain period ahead in the markets:
Stay long, but reduce risk by looking at less expensive (low P/E) and lower volatility (beta) holdings.
Consider raising some cash, or even hedge a portion of the portfolio with a short position. My emphasis is on “hedge.” That means offsetting potential losses with potential gains. In our case, our net gain will come in the form of dividends.
Gold is back as a hedge.
Consider utility stocks.
Of course there is no guarantee that any strategy will work going forward. These are just some examples of ways to be proactive in your investing.
Covestor Ltd. is a registered investment advisor. Covestor licenses investment strategies from its Model Managers to establish investment models. The commentary here is provided as general and impersonal information and should not be construed as recommendations or advice. Information from Model Managers and third-party sources deemed to be reliable but not guaranteed. Past performance is no guarantee of future results. Transaction histories for Covestor models available upon request. Additional important disclosures available at http://site.covestor.com/help/disclosures. For information about Covestor and its services, go to covestor.com or contact Covestor Client Services at (866) 825-3005, x703.