Three steps to a safer portfolio

How to Respond to the Inevitable Market Crash in 2010

Date 18/12/2009

The Right Side

Theo Casey

‘Cautious’ is my watchword for 2010.

The reason for my caution is because the bull market was illegitimate. It wasn’t a response to economic growth or corporate outperformance. The rally happened because central bankers made it happen. Don’t get me wrong, the multi-billion pound stimulus Bernanke, King and the rest of the world’s central bankers heaped upon the market has been a blessing. It’s driven our investments to record levels.

However, it’s unsustainable. When rates go back up, markets will go back down.

Let me explain how the ‘carry trade’ has driven the stock markets…

The carry trade was the cash cow of big City trading strategies. To execute a carry trade, you simply borrow in a low interest rate currency and buy a higher yield currency. The difference between the low yield you pay to borrow and the high yield you receive for your purchased currency is your profit. For example, if you had borrowed yen, you would pay around 0.5% to borrow currency. You take that borrowed currency and buy Australian dollars yielding 4.5%. Assuming that the rates on both currencies are unchanged, you receive 4% of free money.

It really was as simple as that.

How the carry trade spread

Carry trades are not limited to the currency markets.

The strategy can be used to buy assets and when the US and UK cut rates to near zero, that’s exactly what happened. Traders have been borrowing at zero and buying… anything.

It’s been like Christmas everyday. When City traders can borrow at zero and buy government bonds yielding 3.5%, stocks yielding 5% and corporate bonds yielding 7%, it’s little wonder that all of these asset classes has risen simultaneously this year.

It’s easy while the going is good, but rates have to rise some time.

We need to be prepared for when the party stops…

Three steps to a safer portfolio

It will probably come as a surprise, but if the market is going to fall, we just advise that you let it…

Shorting the market, the conventional way, is a mug’s game. If you try and short the stock market as a long term trade you will spend more time losing money than making it. Put simply, the market trends up. Stocks spend a longer amount of time rising than they do falling.

When stocks fall, they tend to fall very sharply in a short space of time.

Calling those downturns is difficult. So we need to be defensive another way.

What do we recommend?

First step, sell your most cyclical holdings.

The priorities of the defensive investor should be to protect your wealth before looking for more. In my subscription newsletter, I’ve taken big profits in some very cyclical and volatile positions. It’s essential to bank profits when the opportunities present themselves.

It’s this ethos that means the first thing you should do when rate rises are back on the cards is to protect what you worked so hard for. So it’s time to think about your highest performing stocks. When markets turn back again, get out of any cyclical holdings you have or prepare to take heavy losses.

The next step is to take those funds and buy defensives and gold.

The case for defensive stocks often falls on deaf ears when the markets are rising. But 2010 will not be like 2009. There are still many big, cash-rich, high yielding blue chips that are worth your money. We recommend moving into the likes of Tesco, Imperial Tobacco and Vodafone when the market turns south.

As for gold, the yellow metal will take up its familiar role as a jolly good hedge when the rest of the world is falling to pieces. In 2008, it was certainly a better place to have your money than in cyclical stocks and so we expect it to prove once again.

The third step, believe it or not, is to buy back into cyclicals.

Buy on the dips. It’s an oldie but a goodie. Once the markets fall sufficiently, delve into the market and pick up cheap businesses.

I highlight ten such opportunities in a recent piece for The Right Side. Aggressive, but currently overvalued opportunities like Burberry, ICAP and Tullow Oil. Too pricey at present, but could be very attractive come the correction.

Hoping for the best, but preparing for the worst. Our three steps are a sequential step down in risk and reward and then back up again. Selling at highs and buying on dips sounds easy on paper though. We will need our wits about us and watch the markets very closely to get these ones right. Rest assured that we’ll let you know when to act.

Watch this space.

Best wishes,

Theo Casey
For The Right Side

Editor's note:

Keep your eye out for this generous offer

Just before you go, here’s something to keep an eye out for. Very soon you are going to learn of a very generous offer.

On Monday 21st December, if you act swiftly, you will be able to get a great deal on a brand new book called Liquid Millionaire. It’s a book that I’ve seen highly recommended.

You’ll get a great chance to see what all the fuss is about. We’ve secured an offer for you to pick up this investment bestseller for just 99p instead of the £22 recommended price.

But… there is only a limited supply of 99 books, so please be quick.

Frank Hemsley,
Editor
For The Right Side

P.S. If you enjoyed this article you can find out more about our free email, The Right Side by clicking here.

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