Jubak's Journal
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4 ways to pad your portfolio for a crash
No, it's not time to run for the hills. But the market swoon on Feb. 22 may have been a preview of worse things to come. Here's how to protect yourself now.
By Jim Jubak
As stock market drops go these days, the 174-point fall in the Dow Jones Industrial Average ($INDU) on Feb. 22 wasn't anything special.
But I hope this one got your attention. In its cause, in the stampede as everyone rushed for the door at once and in the way that "insurance" designed to prevent losses accelerated the U.S. dollar's drop in the currency markets, last Tuesday's tumble was a dry run for a market meltdown. You don't need to turn all your assets into gold coins, bury them in the backyard and then stand guard over them with a gun. But you should take a long hard look at your portfolio to see if you've gradually added more risk recently than is good for you under the circumstances.
I'm taking this wake-up call very seriously because, looking back over the last few months, I've done exactly that. After the back-to-back gains of 2003 and 2004, when the Standard & Poor's 500 ($INX) stock index returned 26% and 9%, respectively, I'd become a tad too complacent. I drifted toward risk and away from safety at the end of 2004 and at the beginning of 2005, in both Jubak's Picks and in my personal portfolio.
So far, the drift hasn't been huge. Jubak's Picks remains at its core a relatively low-risk portfolio. But it's time to guide my portfolios back toward safer waters. And I think I can do that without giving up too much in the way of potential profits.
Lacking energy
So what happened a week ago?
Oil prices climbed, jumping almost 6% to better than $51 a barrel. That certainly didn't help a stock market that can't quite shake its worries about an economic slowdown and a revival of inflation caused by higher energy prices.
But if that had been all that was bugging the stock market, investors would've seen energy stocks such as ChevronTexaco (CVX, news, msgs) and Exxon Mobil (XOM, news, msgs) go up as the rest of the market tumbled. But instead, Exxon Mobil fell $1.16 a share and Chevron was down 39 cents a share. Just about everything was down on the day: Of the 3,462 issues traded on the New York Stock Exchange, more than 75% fell Feb. 22.
So if higher oil prices weren't the main culprit, what was? My vote goes to the U.S. dollar. Currency traders reacted to news that the Bank of Korea had indicated in a report to that country's parliament that it might keep more of its reserves in stronger currencies, such as Australian and Canadian dollars, than in U.S. dollars by selling the dollar and selling it hard. The dollar's fall that day was its biggest in more than six months against the euro, and the U.S. currency dropped against more than 30 currencies, including the Korean won and the Japanese yen.
With global currency markets in turmoil, the central bankers of Korea began back-pedaling as hard as they could. No, they never meant to suggest that they would sell dollars. What they really meant was that the bank wanted to diversify its assets by, you know, buying things like higher-yielding bonds. No big deal. The next morning the bankers firmly announced, "reports that the Bank of Korea will sell dollar assets are false."
Related news and commentary on MSN Money
That was enough to take the currency markets out of panic mode for the moment. But only for the moment. Even though they know Asian central banks will hold as many dollars for as long as they can to protect their export-driven economies, currency traders have been expecting some Asian central bank to begin selling dollars for more than a year. The Korean, Taiwanese and Singaporean central banks have been making it clear for more than a year now that they'd like to reduce the percentage that dollar-denominated U.S. Treasury notes and bonds made up of their assets. It's a short step from statements about the need to diversify to actual dollar selling.
Fear of a panic
With $200 billion in reserves, Korea has the world's fourth-largest foreign-currency reserves and is the globe's fourth-largest holder of U.S. Treasurys. But without a big assist from the currency markets, the Korean announcement wouldn't have made such a huge impact.
Everyone in the currency markets is so afraid of a panic that sends the dollar plunging that they've all set up trades designed to sell dollars at the first sign of trouble. The intention of these trades is to make sure the trader gets out of the market before everyone goes scrambling for an exit, sending prices plunging. That's insurance against big losses.
Well, that's the intent anyway. But we know from crashes in other financial markets that insurance can turn a moderate correction into a full-scale crash. That's what the then-popular portfolio insurance -- a system of automatic trades designed to get investors out of stocks before they suffered big losses -- did in the stock market crash of 1987. On Oct. 19, 1987, the Dow closed down 508 points, after recovering from even worse losses during the day. The S&P 500 fell by 30% and the Nasdaq Composite ($COMPX) fell 15%.
A major part of the problem, the report from the commission headed by Nicholas Brady that studied the crash concluded, was portfolio insurance. By making sure that everyone rushed for the door at the same time, it assured that many stocks simply couldn't find buyers. Even blue-chip stocks like Procter & Gamble (PG, news, msgs) fell $1, then $2, then $5 and then finally $7 before buyers appeared.
The best minds
Now I don't know how the structure of computerized trades, swaps and derivatives would play out if the currency markets came under real pressure. I don't think anyone does. Remember that in 1987, the market didn't crash because of a lack of brainpower or diligence. Wall Street's best minds had built the complex strategies that were supposed to protect their clients, and these strategies had been tested and tested again. And still they failed in unpredictable ways.
Investors face a similar problem in the currency markets today. Nobody knows how they'll behave under stress. But if the dollar's fall on Feb. 22 is any indication, the dynamics of the currency market now are set up to amplify bad news, or even the rumor of bad news, and turn orderly selling into a rout.
That's not the most likely scenario now. I still favor the idea that the financial markets will keep on muddling through this year. Short-term interest rates will climb to 4% by the end of 2005, lending the dollar critical support. Global holdings of the U.S. dollar will continue to shrink in a relatively orderly fashion. In 2001, 67% of the world's foreign-exchange holdings were in dollars. The figure had fallen to 64% by 2003. UBS AG (UBS, news, msgs) recently predicted that the euro, which now accounts for 20% of foreign-exchange holdings, will gradually make up 25% to 30%. By the end of the year, the dollar could be down another 6% against the euro. All that would slow global and domestic growth, but certainly not bring it to a halt.
So on the one hand, I can't dismiss the chance that the next time there's a repeat of the Feb. 22 currency rout, it won't be so easily contained. On the other hand, I can't say for certain that the financial markets will respond to the stress of a global readjustment in the dollar's value with a 1987-like crash.
4 steps to take
So what's the best strategy for these circumstances?- Increase your position in gold, the only sector that climbed on Feb. 22. I think it would do well in the event of a major market break. (That's the term that the Brady Commission came up with for the October 1987 crash.) In Jubak's Picks, I'll be looking for a third stock to add to my existing two-stock gold position of Newmont Mining (NEM, news, msgs) and Placer Dome (PDG, news, msgs). Adding a third stock would move my gold allocation from slightly under 10% to slightly over 10%, which is reasonable now.
- Cut your exposure to high-multiple, high-momentum sectors and stocks. Momentum investors will be first out the door in a market break, and these stocks aren't likely to find buyers until they've fallen substantially. And if investors remain in worry mode, as is likely this year, these stocks are likely to underperform traditional haven sectors and names. With this column, for example, I'm going to sell my position in the Biotech HOLDRs (BBH, news, msgs). I'll be looking to sell other risky positions as market rallies give me good exit points: I'm not particularly interested in taking a bath as I reposition my portfolios.
- Don't load up on big-name, large-market capitalization blue chips out of a conviction that they'll provide a refuge in a big market decline. The big liquid names owned by institutions are likely to be sold heavily as a result of "loss-prevention" strategies put in place by big institutions. Investors will be much safer -- granted that's a relative term, since all stocks will fall in a crash -- with mid-cap stocks in safe sectors, especially if they're trading at price-to-earnings ratios below the market average. What I'd call mid-cap blue chips also are likely to show better earnings growth than their large-cap relatives. Corn Products International (CPO, news, msgs) is an example of this kind of blue-chip mid-cap with a solid growth story. I'll be adding it to Jubak's Picks with this column.
- Raise cash. Holding some cash will make you feel better if something bad does happen and that, in and of itself, will let you think more clearly about what to buy and sell. With market volatility high, you're likely to get a chance to put that cash to work at good prices even if we don't get a major market event. How much cash? I'd say move toward the top half of your normal cash range, if you have a range. If you don't, this would be a good time to move toward 10% cash or so.
These aren't radical steps, and I'm sure the more bearish of my readers will condemn this strategy as doing too little, too late.
Going to 100% cash or putting it all in gold would certainly be safer. But my idea is to try to make money if the market doesn't crash -- still the most likely case -- and to protect myself at a reasonable cost from the worst consequences of a possible, but not highly probable, event.
Call it doing a little, too early. Or maybe, I hope, at just the right time.
Changes to Jubak's Picks
Sell Biotech HOLDRs
This one hasn't worked out as a hoped, and I think it's time to move on. I added Biotech HOLDRs (BBH, news, msgs) to Jubak's Picks on Sept. 28, 2004, because the biotech sector had outperformed in August and September and that, according to my September effect theory, marked the sector for 12 months of strong performance. But I think something has gone awry here. The most likely culprit is persistent market worries that continue to shift money into safe sectors, such as oil and gas. February also marks the end of what is traditionally one of the strongest seasons for the biotech sector; March is traditionally among the weakest months of the year for these stocks. I'm selling the Biotech HOLDRs out of Jubak's Picks with a gain of 1.4%.
Buy Corn Products International
Corn Products International (CPO, news, msgs) turns corn into such things as corn starch (used to make paper and textiles), high-fructose corn syrup (used in soft drinks), glucose corn syrup (used in hundreds of food products) and high-maltose corn syrup (used in sports drinks and candy.) Byproducts, themselves pretty profitable, include corn oil, corn feed and corn protein. The company looks set to get a big boost to margins and sales. A big increase in the U.S. corn crop, in part the result of farmers switching from soy beans to corn to escape the latest rust outbreak, should lead to lower corn prices and lower costs for Corn Products International. A weaker dollar should increase sales overseas, as the companys products get the benefit of a cheaper dollar, and increase earnings as revenues in stronger local overseas currencies are translated back into dollars on the companys books. In the current stock market, I especially like the combination of above-average earnings growth -- a projected 117% for 2005 and 15% for 2006 -- with a below-average price-to-earnings ratio (19.3 versus 22.9 for the S&P 500 stocks). I'm buying this one on the dip: The shares recently dipped below the 50-day average and then recovered to close above that level on Feb. 25. I'm adding the stock to Jubak's Picks with a target price of $32 a share by September 2005.
New developments on past columns
5 property development plays
I got a bushel of e-mail from readers offering their own land-stock favorites after I recommended five timber stocks with real estate development potential in my Feb. 23 column and CNBC TV appearance. Let me pass along those suggestions to you for further research and study: Alexander & Baldwin (ALEX, news, msgs), Alico (ALCO, news, msgs), Bowater (BOW, news, msgs), Consolidated-Tomoka Land (CTO, news, msgs) and SJW (SJW, news, msgs). Thanks to everyone who sent along a stock research suggestion.
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Newmont Mining and Placer Dome Gold. He does not own short positions in any stock mentioned in this column.
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