Weekends provide a valuable time for investors to pause and
reflect. That's because during the week there is such information
overload that it's often hard to bring the full investment
landscape into focus.
So this weekend I did some hard reflection regarding the "big
picture" right now. The problem is that I see two potential
outcomes. One is great for investors. One is horrifying. And
because of that I have adopted a portfolio that prepares for these
two diverse outcomes.
Let's start by discussing the two disparate investment
Big Picture #1
: Moderately improving economy = moderately improving corporate
earnings = moderately improving stock market. I shared the core
fundamentals reasons for this pro-stock stance in an article I
posted on Seeking Alpha earlier in the month entitled
4 Reasons Why Stocks Are Ready to Make New
Big Picture #2
: Potential disaster from (take your pick of)
- Fresh eurozone credit problems. Ireland now. Who's next? And
does it wash to our shores?
- Mortgage/banking issues perhaps not truly fixed.
- Enormous US debt burden (federal and state) that others may
not want to finance much longer. (aka sovereign debt crisis)
- Quantitative Easing Part 2 (QE2) policies that have many
critics and many potentially harmful unintended consequences like
dollar devaluation, currency war, rampant inflation etc.
- And if any of these really took root, then yes, double dip
recession and all the pain that comes with it.
I still think that the strong preponderance of the evidence
points to the modestly bullish case (Big Picture #1) being the most
plausible. Yet that doesn't mean we should cast a blind eye to case
#2. I talked about this same scenario back in late August when the
market was pressing down on Dow 10,000 (see
Russian Roulette, Stock Market Style
I wrote that article to make the case for not giving into the
rising fear. Instead folks should stay invested in stocks given the
positive fundamental outlook. That was the right call then. But now
the market is 12% higher. Is it now perhaps prudent to pull in the
reigns a bit just in case any of the pitfalls of Big Picture #2
Portfolio Insurance Is the Answer
To be clear, I am not running for the hills as I still suspect
the muddle through case for the economy and stocks is the most
likely. However, if something blows up overnight, as it has in the
past, then buying protection afterwards may be too late. So best to
take on some positions that act like portfolio insurance. And yes,
insurance always seems like a waste of money until you need it.
Maybe we need it given the growing list of concerns I shared
The two most likely kinds of disasters that could take place
overnight leading to heavy losses as the market opens the next day
would be the following:
Sovereign Debt Crisis
We clearly have a ton of debt on the books (and off the books
too). At some point there may be no more appetite for government
debt at such low rates leading to a tremendous spike in rates. The
best form of insurance here would come from ETFs that profit as
rates rise. Or simply, they short US bonds. My personal favorite
choice is [[TBT]] which is a 2X short of the 20+ year
If you have a good appetite for risk then you can ratchet up to
3X shorts like [[TMV]] and [[SBND]]. On the other hand, if you
don't care for all that leverage then just go with [[TBF]] which is
the 1X version of what [[TBT]] is doing.
Since 2008 I have stayed away from bank stocks with a 100 foot
pole (ten foot pole was just not good enough). Why's that? To me
the banks and the Government are acting like my 8 and 10 year old
How's that? When I ask them to clean up their rooms, they scurry
around as fast as possible and throw all their stuff in the
closets. On the surface the room is clean. Then when you open up
the closets you get buried under all the garbage they threw in
To me that is how the government and the banks cleaned up the
mortgage mess. I don't think the bad debt is really cleaned up. I
just think it's hidden in the closet and under the beds (so to
And the more I read about it, the more uncomfortable I become.
The recent mortgage foreclosure problems being the most recent
hiccup. And I am concerned there are more to come.
So if there is another weekend in our future where we discover
another Bear Stearns/Lehman type scenario, then shorting bank
stocks on Monday morning will be too late. Better consider that now
as further portfolio insurance.
I don't think it wise to try and pick and choose which of the
big banks will falter. If something new hits, it will most likely
mean they are all in trouble. So best that you go with an ETF that
rounds up all the usual suspects ([[BAC]], [[C]], [[JPM]], [[WFC]]
On the ETF front you have a number of good ETF choices like
[[FAZ]], [[SEF]], [[SKF]], and [[UYG]]. Just make sure the holdings
of the fund focuses more on the big money center banks and doesn't
really include much in the way of insurance companies or credit
Putting Everything in Focus
I know that discussing a potential banking or sovereign debt
crisis makes it sound like it's "game over" for the stock market.
Yet that is not the point of this article.
The simplest way for me to say it is that I still think the
preponderance of the evidence points towards a muddle through
economy with modestly improving corporate earnings and modestly
higher stock prices. That is why I am currently 75% long the stock
However, given my rising concerns about the banks and government
debt, then I have taken the rest of the funds to buy myself some
portfolio insurance against these potential calamities. My true
hope and desire is that my stocks keep rising and I end up selling
these defensive positions down the road for a loss. Yet I will
certainly sleep better at night knowing that I do have these
insurance policies in place in case trouble does start to brew. I
hope you consider the same if you haven't already.
I own [[TBT]] and [[SKF]]
CEF Weekly Review: The Elephant in the Room