Thursday, March 8, 2012

How to Hedge Against Risks Now

There seems plenty to be happy about these days. The Dow this week closed above 13,000 for the first time in years, and just 9% shy of its all-time record. Europe is working hard to solve its debt crisis. And, the U.S. economy is showing signs of strength.


But, according to David Kelly, the Chief Market Strategist for J.P. Morgan Funds, "there are still issues on the horizon which could trigger both a market correction and a weaker global economy."

What are those issues? And more importantly what are the best ways to hedge against or take advantage of a market correction and a weaker global economy should that become a reality?

The issues are really one issue, according to Malcolm Polley, a CFA charterholder and executive vice president and managing director of S&T Wealth Management. And that's the sovereign debt problem and its potential impact on both European banking capital and the European economy.

"While Greece is the country that's talked about most, the really issue would be if Italy and Spain come to grips with their debt issues with austerity programs that cause their economies to go into recession, that could, in turn drag the eurozone into recession."

And since the eurozone is a big importer of U.S. goods that would also drag down U.S. imports which could then drag down our own economy, Polley said. "Couple that with the realization that the vast majority of German exports go elsewhere within the eurozone, if the eurozone goes into recession would that drag down its best performing economy?"

So what investments make sense given all that? Well, it might not be all that exciting, but Polley said you do it by increasing the certainty from your investments. "That could mean increased investing in money market or other relatively certain return vehicles," he said. "Unfortunately, the returns are patently unexciting."

And, you might also consider investing in shorter-term fixed income investments, while giving slightly higher returns, also provides very low returns, he said.

As for equities, Polley recommends "domestic investments with a higher degree of certainty." Again, it's a familiar theme. But this means focusing on "stocks that pay dividends so that you're not as reliant on capital appreciation for all of your returns."

Some options to consider: iShares Dow Jones Select Dividend (DVY : 55.02, 0.22, 0.40%) or the iShares High Dividend Equity Fund HDV (HDV: 56.20, 0.11, 0.20%) .

And if you want to hedge against a market correction with something with a little more razzle-dazzle, consider an alternative strategy such as merger-arbitrage, which, according to Polley, "provide relatively stable, if low, returns over time."

A merger-arbitrage strategy is seeks to capture the spread that often exists between the proposed offering price and the market price of a merger target's public stock.

One fund to consider suggested by Polley is the Gabelli ABC fund (GABCX). Other options include: the Credit Suisse Merger Arbitrage Liquid Index (CSMA: 20.38, 0.06, 0.30%); IndexIQ IQ Merger Arbitrage ETF (MNA : 25.71, 0.39, 1.54%); The Gabelli Global Deal Fund GDL; Quaker Event Arbitrage A (QEAAX); Touchstone Merger Arbitrage Fund (TMGAX); Arbitrage Fund (ARBFX); and Merger Fund (MERFX).

Polley said, "We believe that spending at least as much of your investment energy concentrating on return of capital as return on capital will hold your portfolios in good stead over these -- relatively -- uncertain times.

Others, meanwhile, see a different set of issues that could result in a market correction and a weaker global economy.

"The issues is Iran and the better-than-average probability there is a military strike (Israeli most likely) on their purported nuclear facilities," said Eric M. Lohmeier, a CFA charterholder and managing director at NCP, Inc.

From Lohmeier's perspective, we're not just talking the "potential for a regional/global conflict in the Middle East, but one that centers on the second largest oil-exporting country in the region and the third in the world -- and probably more importantly a nation, that being Iran, that could wreak havoc in the Strait of Hormuz given that 20% of all the world's oil passes through this strait."

Of course, the potential for such hostilities is already being priced into the price of crude oil, said Lohmeier. (Brent Crude spot prices at now at two-year highs: $125 a barrel vs. $70 a barrel in the spring 2010.)

And the effect of that increase is taking a toll. "Increasing the price of oil is best described as a direct tax on both consumers and businesses globally," said Lohmeier.

"So what we have is a U.S. economy and consumer confidence that finally look to be on a more sustainable growth trajectory, and lo and behold, we are within 10% of an average price for unleaded gasoline of $4.00 per gallon -- with real upside from there."

So the ultimate risk today, according to Lohmeier, is directly correlated with how the world deals with what appears to be an openly more hostile and nuclear ambitious Iran.

"The U.S. consumer has probably been the most pleasant upside surprise of the past six months, and you get what amounts to a direct tax hit with an inelastic short-term demand item, that being gasoline." In effect, you take the wind out of the sails of a measured global recovery.

Meanwhile, Sean Barron, a CFA charterholder and portfolio manager with Delta Trust & Bank, doesn't think the issues that could topple the market are just Iran or just the sovereign debt problem in Europe.

Rather, it's a plethora of issues, including the aforementioned as well as a hard landing in China, the election in U.S., the housing market and job creation, and the world's reliance on China and U.S. for economic growth.

So, to hedge and protect against all that could go wrong, Barron is "very slightly overweight risk in our portfolios." The current portfolio, for instance, allows upside participation (equities and high yield), while providing some downside hedge (favoring U.S. equities over developed markets ex-U.S. and an overweight to gold).

To be sure, we're not saying the sky is falling. But if it does, we just want to make sure you have an umbrella.here seems plenty to be happy about these days. The Dow this week closed above 13,000 for the first time in years, and just 9% shy of its all-time record. Europe is working hard to solve its debt crisis. And, the U.S. economy is showing signs of strength.

But, according to David Kelly, the Chief Market Strategist for J.P. Morgan Funds, "there are still issues on the horizon which could trigger both a market correction and a weaker global economy."

What are those issues? And more importantly what are the best ways to hedge against or take advantage of a market correction and a weaker global economy should that become a reality?

smartmoney.com

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