Playing Defense

June 22, 2006 by  


By Bob Wood

As I write this column in late August, the major indices for domestic stock markets have all turned negative for the year. Even with raging optimism still coming from promoters in the business media, stocks are selling with no robust catalyst to move them higher in price. What’s an investor to do?

The best move now, in my not-so-humble opinion, is putting your best defensive players on the field and sending your offensive players to the sidelines for what could be a rather long break in action. So what’s your best defensive investment option? I’m sure regular readers already know which asset classes I’d choose.

As the opinions I share in this column tend to be rather different than more popular views, you might want to remind yourself that the previous bear market in stocks, during the first three years of this decade, produced large losses for many investors. And within that time, typically, you heard bullish advice from the brokers and promoters on CNBC.

While promoters use any downturn in stocks to justify buying on the dips — in anticipation of the next move higher, I am quite sure that the next move downward will continue the longer term, secular bear market, which began in March 2000. And I am sure because that’s how the stock market works. Long bull markets — like the one enjoyed during the 1982-2000 period — are always, and I do mean always, followed by bear markets for about the same length of time.

And none other than serial bubble-blower Alan Greenspan warned this week that investors settling for low-risk premiums in investments were due to realize low future returns. That stocks are now selling at close to 20 times earnings fits the low-risk-premium definition well. On top of the high prices asked for stocks, high energy prices and the war in Iraq, which some consider much less than a success, we are seeing an investing environment that looks more like the 1970s and Nixon’s second term. And that’s rather spooky.

Those with an appreciation for modern history remember that decade as a low point for equity investors who fought the prevailing trend — the secular bear market that began in 1964. The fundamental backdrop of losing a war and experiencing high inflation and rapidly rising energy prices made stocks one of the worst-performing assets classes for investments.

So, if you agree with my premise, how can you best position yourself to enjoy the return of your money, with returns on your money a secondary concern? Send in your defensive players! Use them at your own discretion, but use them liberally. And the best defense, of course, is simply avoid playing the game at all. Sitting on your cash could prove the least stressful option of all.

If you are inclined to invest in bonds, don’t be afraid to add to those holdings now. As fruitless as accepting a 4% yield on 10-year maturities seems now, with erosion to those gains from taxes and inflation, large investors are still buying bonds for some reason. Those low yields may look mighty good in a couple years, if stock market losses increase. International bonds are the option of choice for me, with the dollar’s sinking value offering a currency gain along with interest gains.

Consider some other asset classes, too. By that, I mean bear market mutual funds, commodities and precious metals. Luckily, these options are all available in no-load mutual fund form.

Bear market funds are designed to make money when the stock market falls. These funds come in different forms, which you can combine to diversify your bear market risks, much as you would diversify your traditional long investments. Adding bear market funds to your favorite long-only funds provides even deeper diversification to smooth performance during the counter-trend rallies that inevitably occur, regardless of the longer-term market direction.

This strategy represents, for me, the way to invest in secular bear markets. Used in combination with your favorite traditional mutual funds, shares of BEARX, PSPSX or RYAIX — the bear market funds I normally use — can ease the pain caused by adhering to ‘’stocks for the long run’’ nonsense during market drops, while keeping some exposure to a rising counter-trend market rise, such as seen in 2002 – 2003.

In precious metals, we find one asset class that almost reliably moves opposite to the major stock market indices like the Dow or S&P 500. When stocks perform poorly, investors looking for safer alternatives consider assets with real, underlying value, such as gold or silver. Gold and metals funds are plentiful enough and safer than individual stocks in that sector.

Commodity-based funds offer the same ‘’hard asset’’ comfort, where investors know that, unlike stocks, a definable value exists for things like gold, oil, copper or rice. The best option in this narrow field is POCMX, a no-load fund holding actual commodities, based on popular “basket” compositions used by commodity investors.

I might consider advocating real estate investments, too, except that the whole idea has been played out — with speculation now running rampant. Maybe when no one is talking about real estate and prices are making sellers glum, adding real estate exposure will make sense again.

The thinking behind investing in hard assets is summed up briefly in something I read today. The writer, William Boyer, questions the viability of stock market investing in much the same way that I do:

“…analyzing a stock reveals that people actually own nearly nothing except the hope that someone will come along and will want to pay more for their stock than they paid… Real property provides profits through rent or business production and provides a claim on the profit as a result of ownership, but a share of stock in a corporation provides no claim on any of the profits. In reality, a stock certificate offers no substantive claim for anything.”

And while I firmly believe Boyer’s premise, I do hold shares of some stocks in client accounts — but only those that seem positioned to benefit from a defensive strategy. But all client accounts contain at least half their value in these alternative, defensive options that actually do represent claims on substantive value, such as international bonds (where appropriate), commodities and cash.

Holding positions in mutual funds that offset risk and losses in a down market (like those mentioned above) and keeping stock exposure only in markets enjoying secular bull markets round out my short list of acceptable options. This strategy holds true with my firm belief that even though bear markets prevail, bull markets are still available for participation — somewhere.

Smart money is always looking the world over for places and things for investing that offer better returns. And while your best defensive players can keep you from taking a big hit, they can sometimes score for you too. In this way, the well-positioned investor can attempt to combine the return of his money with some return on his money. And that’s a productive use of the defensive strategy!

Have a great week,
Bob

8-26

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