Recession Proof Your Portfolio

Although I remain relatively bullish on the economy and markets, I also recommend taking steps to recession proof your investment portfolio. 

In last week’s issue of Personal Finance Weekly, No Double-Dip Recession, I analyzed recent economic data and concluded that the US economy is unlikely to slide into a double-dip recession.

The hard numbers suggest that the US is headed for a weaker-than-normal recovery and that unemployment will remain elevated for some time–but a double dip doesn’t appear to be in the cards.

Avoiding a double-dip recession doesn’t mean that the stock market is off to the races again. Odds are the S&P 500 will at least re-test its July lows of 1,110 this autumn, and it’s quite possible the index will break psychological support at 1,000 and re-test levels closer to 950. 

Many investors are under the impression that a market correction of more than 20 percent is a sure sign that the economy is headed for recession. There’s an old saw on Wall Street that the market has predicted 10 of the past two recessions; history abounds with examples where the market dropped 20 percent from a high, but the US economy avoided another downturn.

That being said, just because the economy as a whole hasn’t fallen prey to recession doesn’t mean that certain sectors and industries aren’t contracting.

For example, one of the big differences between the economy’s recovery from this downturn and a “normal” recovery is that the US consumer is far less inclined to spend the country out of recession. This is why I’ve advised Personal Finance readers to avoid retailers and other US consumer-focused groups.

Finally, absolute terms don’t mesh with investing. I believe the risks of a double-dip recession are low and that the broader market is overestimating those risks. I base this conclusion on my reading of economic indicators that have proven their worth and have correctly called the turning point for the economy in the past.

This is far different from saying that there’s no chance of a double-dip recession. The possibility exists, and the recent slowdown suggests that the risk of contraction has increased relative to where it was at the beginning of 2010.

All this means that every investor, no matter how bullish, should take steps to recession proof his or her portfolio and hedge against a broader and more severe decline in the stock market. Here are three hedging techniques to consider this summer. Future installments of Personal Finance Weekly will address additional strategies.

Recession Proof Tactic No. 1: Shorts

Short selling is a way to bet that a stock will decline in value. Let’s say you sell 100 shares of a stock short at $50, and that stock declines to $40. When you close the short–known as buying to cover–you’d make $1,000 ($10 gain x 100 shares). Many investors are afraid to short stocks and regard the practice as inherently risky. This is simply not true.

The most common reason investors avoid shorts: You can lose more than 100 percent on your investment and your loss potential is infinite. Though technically true, these cavils boil down to a meaningless statement.

If you sell a stock short at $50 and it goes up by more than 100 percent, you would lose more than 100 percent of your original stake in the short. And if that stock rose to infinity, you would lose an infinite amount.

But ask yourself this question: How many stocks have appreciated 100 percent overnight in recent months? Such a move is uncommon. And if a short play moves significantly against you, simply exit the position and take your losses–the medicine is the same as when an equity holding tanks.

Please get in touch if you know of a stock that has gone to infinity or, better yet, appears poised to break to infinity.

The only thing you need to do before shorting a stock is to make sure you have a margin account with your broker. Any major broker can execute your short trade, either online or over the telephone.

Still scared of shorting? In recent years, a bevy of exchange-traded funds (ETF) have emerged that appreciate when a particular index of stocks declines in value. In other words, when you buy these funds, you’re effectively shorting an index. Examples include ProShares Short S&P 500 (NYSE: SH) and ProShares Short Russell 2000 (NYSE: RWM).

In The Energy Strategist, I recently recommended shorting an alternative-energy company and a deepwater driller that’s been hit hard by the drilling moratorium in the US Gulf of Mexico. I am also looking to add short exposure to the portfolio in the event the broader market rallies, likely through an ETF. If you’re interested in the specifics of these recommendations, sign up for a 30-day free trial of The Energy Strategist.

I’m also monitoring the consumer-discretionary sector for potential shorts.

Recession Proof Tactic 2: Put-Option Insurance

Many investors view options as a purely speculative tool–a way to supercharge returns in the stock market. Certainly, options can be employed in that manner, but that’s far from the whole story. In The Energy Strategist, I frequently recommended using a handful of basic options strategies as a means of reducing risk and making it easier to sleep during choppy markets.

One of the simplest and most effective strategies is put-option insurance. Let’s take the case of hypothetical stock ABC. You purchased 100 shares of ABC one year ago, and it has rallied 50 percent to $50 per share. Given the big run-up in stocks since their 2009 lows, many investors are in this boat; they expect further upside but are afraid a market correction will wipe out their heard-earned profits.

A 50 percent gain is worth protecting. To help insure your gains through December, you could purchase ABC December $50 put options. A put option gives the buyer the right to sell a stock at a specified strike price for a certain period. In this case, a December $50 put on ABC would give the buyer the right to sell ABC for $50 per share at any time until December options expire (usually the Friday before the third Saturday of the month). 

Put options are normally traded in contracts covering 100 shares but are quoted in terms of a single share. Let’s say you find the December $50 puts are trading at $3.50; in that case, a put-option contract covering 100 shares would cost $350. Assuming you purchase that put-option contract covering your 100 shares, there are three basic potential outcomes when the puts expire:

ABC stays put near current levels. In this case, your puts would expire worthless, and you would lose the entire $350 you spent. You would still own your 100 shares of ABC and retain whatever profit you have in the stock.

ABC falls to $35. Your puts are now worth $15 because ABC is trading at $35, but your puts give you the right to sell the stock at $50 ($50 minus $35 is $15), a total of $1,500 per contract. Your profit would be $1,150 on the options ($1,500 minus your $350 purchase price).

In this case, the value of your ABC stock would have declined by $15 per share, or $1,500 for the whole position. But the good news is that your $1,150 profit in the puts protects you against most of the loss in the stock. Buying the puts allowed you to insure your gains against loss. 

ABC soars to $100. In this case, your puts are worthless because there is no value in a contract that allows you to sell ABC at $50 when it trades at $100 in the open market.

However, that loss is balanced by a commensurate gain in the value of ABC. The net effect: You’ve made an additional $5,000 on ABC, and your only loss is the minor $350 fee you paid for the puts. 

Put insurance is a highly effective and flexible strategy that can be used on any portfolio holding regardless of whether you have a profit in the stock. However, investors need to take care when timing their purchase of put insurance.

The best time to buy put insurance is when the market is quiet because options tend to become more expensive volatile or falling markets. One indicator of options costs to watch is the S&P Volatility Index, or “VIX,” a measure of the volatility priced in the S&P options market.

Source: Stockcharts.com

As you can see, the VIX remains relatively elevated right now, but is well off the highs it reached in May and June. Now is a good time to buy put insurance for some of your holdings if you expect a selloff this autumn.

Recession Proof Tactic 3: Income Stocks

In a broader market decline, no stock is immune to selling pressure. However, regular paychecks from stocks that pay a dividend or distribution can help shield you against capital losses from the decline in the market.

The key is sustainability. One of the biggest mistakes you can make as an income investor is to simply look for stocks offering the highest yields; a stock that yield 20 percent usually won’t be able to sustain its payout over the longer term. My colleague Roger Conrad always stresses that investors must examine the business underlying each dividend-paying stock and assess its ability to maintain its quarterly payouts.

Better still are companies with the scope to grow their dividends over time. Many of my favorite income stocks managed to raise distributions in 2008, an impressive show of strength at the height of the financial crisis and stock market meltdown.

Energy-focused master limited partnerships (MLP), a group Roger Conrad and I cover in MLP Profits, are one of my favorite income-oriented plays. For example, Enterprise Products Partners LP (NYSE: EPD) yields more than 6 percent and has increased its payout for 23 consecutive quarters.

The MLP is involved in the midstream energy business, owning assets such as pipelines and gas- storage facilities. Cash flows generated by most midstream energy assets have no significant exposure to commodity prices; customers wishing to ship natural gas over a pipeline simply pay a fee for the use of the pipe. If you’re interesting in reading more about MLPs, their tax advantages and our recommendations–some of which yield north of 10 percent–click here to sign up for a free trial of MLP Profits.

Join my Next Chat

I love my hometown, but much of the Washington, DC area is essentially a drained swamp. And, as most readers are aware, swamps can get hot and humid, which means thunderstorms are a constant threat.

But despite rumblings of thunder and periodic power outages, on Monday I managed to host my second live chat with subscribers to my paid advisory, The Energy Strategist. I answered dozens of questions during the two-hour session, discussing the economy and the winners and losers from the BP (NYSE: BP) oil spill in the Gulf of Mexico.

These informal sessions allow subscribers to ask about any topic on their mind, from developments in energy markets to the prospects for individual stocks. The next chat will occur later this month.

If you’d like to try The Energy Strategist and participate in our next chat session, now is your opportunity to take advantage of the first free trial in the history of the service. Click here for more details.