More Downside Ahead

The S&P 500 managed a modest bounce higher over the past week, but this modicum of positive news doesn’t mark the end of the broader market correction that began in early April. The past week’s rally is what traders call an “oversold” bounce.

While stocks could rally a bit more from current levels, I advise investors to use this rally as an opportunity to hedge their portfolios against further declines in the broader market.

For the past few months, I’ve been reducing risk in the Personal Finance Growth Portfolio, by selling longstanding recommendations that were showing tremendous gains and trading well above my recommended buy prices, such as technology giant IBM (NYSE: IBM).

I‘ve also been recommending that investors boost their exposure to more defensive groups such as consumer staples stocks. This sector includes food companies such as Growth Portfolio recommendation Kraft Foods (NYSE: KFT).

In particular, I continue to favor consumer staples stocks that offer a decent yield and susceptibility to upside catalysts that are independent of market conditions. Kraft, for example, provides a 3 percent dividend yield and should benefit from the company’s planned split into two different publicly traded firms.

Kraft will create a North American grocery business that pays an ample dividend and sells such products as Maxwell House coffee and Oscar Mayer meats, as well as an international snacks business that sells Oreo cookies, Trident gum and Cadbury chocolates. Kraft plans to separate its financial statements in the second quarter of 2012 and finalize the split before the end of the year.

Defensive moves of this nature won’t completely protect your portfolio when a broader market sell-off occurs, but they can limit your downside and keep your capital intact so you can profit from the eventual upturn. 

More Aggressive Tactics

For those with a more aggressive investment style, this also marks a good time to load up on a few hedges to protect your downside risk. In The Energy Strategist, I recommend taking a position in the ProShares Short S&P 500 Fund (NYSE: SH), an exchange-traded fund (ETF) that tracks the inverse of the daily performance of the S&P 500. That means, when the S&P 500 falls by 1 percent in a given session, ProShares should rally by about 1 percent.

Inverse ETFs such as ProShares aren’t foolproof instruments and over longer periods of time they can experience significant tracking error. While the ETF is designed to track the inverse daily performance of the S&P 500, and has done so quite successfully, that doesn’t mean the ETF will perfectly follow this track over a 1-2 month period.

That said, in prior risk-off cycles such as we saw in the summers of 2010 and 2011, ProShares has seen significant upside and can help offset losses in other segments of your portfolio. Ultimately, I am looking for the S&P 500 to fall to around 1,220, about 100 points below the current quote, before this correction is complete.

Three basic factors are driving this pullback: the continuing sovereign debt crisis in Europe, weaker US economic data and the looming US fiscal cliff. As I’ve been predicting for some time in PF Weekly, US economic data has softened in recent weeks, as the seasonal tailwinds caused by one of the warmest winters in US history have dissipated.

This trend could continue to be a headwind for stocks for a few more weeks, although I’m encouraged by the recent stabilization in the data. US initial jobless claims are trending lower again and the Purchasing Manager’s Index (PMI) for manufacturing is in the mid-50s, a level that typically suggests solid economic growth. The US consumer also will likely get a boost from the decline in crude oil and retail gasoline prices, just as the summer driving season gets underway. Bottom line: it’s far too early to signal an “all clear” for the economy, but the deterioration in economic data isn’t as severe as it was one year ago.

The Mess in Europe

Simply put, Europe is a mess. Greece’s chronic woes now dominate the front pages, with the country at risk of getting forced out of the euro if it elects an anti-austerity government on June 17. The current odds of a Greek euro exit on stand at about 40 percent by the end of 2012 and 60 percent by the end of next year.

Nonetheless, the euro debt contagion is prompting EU leaders to take additional steps to alleviate the crisis. In particular, Germany’s opposition to such measures such as euro-area bond issues may be weakening. I’m also encouraged to see Italian 10-year bond yields still well under 6 percent, a sign that the market has growing confidence in efforts undertaken by Mario Monti’s technocratic government to bring the nation’s budget into balance.

The looming fiscal cliff in the US remains a headwind for stocks. If Congress does nothing before the end of the year, the country will face the biggest fiscal contraction since World War II. The list of fiscal adjustments includes both tax increases and spending cuts. There’s unlikely to be much movement on a compromise until after the November elections, but the odds are high that the US government will remain divided regardless of whether Barack Obama or Mitt Romney wins, with different parties controlling Congress and the presidency. A grand bargain is likely before year-end or in early 2013, to postpone some or all of the scheduled fiscal tightening.

Stocks will probably continue lower this summer, but none of these aforementioned drivers are deathblows for the economy. I continue to regard this sell-off as a nasty correction within a broader uptrend, not the beginning of a new bear market. I’m sticking with my view that the US economy will grow at a lackluster 2 percent to 3 percent pace over the next 12 months, just as it has over the past year.

Longer-term investors should regard this sell-off as a golden opportunity to buy stocks at attractive prices. My favorite buys during market downturns are high-yield groups such as master limited partnerships (MLPs). Keep in mind, MLPs aren’t immune to broader market selling. Indeed, one of the topics at this week’s MLP Investor Conference in Greenwich, CT was the fact that many MLPs have actually fallen faster than the broader market over the past few weeks. That’s because markets are in “risk-off” mode, meaning that investors are reallocating money out of all stocks and commodities in favor of US government bonds and cash, regardless of underlying fundamentals.
In many cases, the recent sell-off offers investors the opportunity to buy MLPs at yields 1 percent to 3 percent higher than was possible just a month or two ago. Investors looking to enter the MLP arena should consider dividing their intended investment into three or more tranches, investing one tranche of capital now and using further declines in the broader market to add to their positions. Over the past few years, high-yield groups such as MLPs have been faster to recover than the broader market.