The Best Offense is a Good Defense

Andrew Packer (July 30, 2010)

Why the Market is Moving Down and 3 Simple
Ways to Protect Yourself

Technical indicators. A market rising on nearly no volume. A weak earnings season. All these factors are telling us markets have moved up too far, too fast—at least in the short run.

Since May’s peak, each market rally has been met with a lower high point… and a lower low point.

It’s pretty obvious that, for bellwether companies like DuPont, this pattern means there will be some nice moves upward over the next few months– followed by worse moves downward.

Fun With Technicals: Lower Highs and Lower Lows = A Bad Sign For Markets

What about earnings? Well, outside of Apple, which has a staggering 24% weighting in the Nasdaq, earnings have been pretty weak. Even when earnings have met expectations, shares have still lagged.

Last Friday, for example, McDonald’s increased sales by 12% and beat analyst expectations by just a penny. Shares sold off. Amazon missed its earnings slightly, and sold off by nearly 10%. Yikes!

So, with markets already on a longer-term trend for the worse, get on the defensive. Here are three ways:

1. Hoard Your Stash: Physical Gold and Silver

Sure, it’s cliché. Stay on the defense with gold and silver. But I’m not talking about investing in a gold ETF or fund, or even mining shares. You see, daily gold and silver prices come from the options market—where the outstanding options vastly exceed the amount of gold and silver actually in existence.

That’s right; there’s only enough physical gold to cover about 3% of all the outstanding gold contracts out there—so it’d be impossible for all parties to take physical delivery.

That’s why the price of gold is artificially low—so bulk up on the physical now.

Most of your defensive portfolio should go to gold, with some left over for small, easily divisible quantities of silver.

You’ll also want to make your purchases before January 2012, as I stated Tuesday, thanks to new reporting requirements sneaked into the health care reform bill.

The new legislation affects sales over $600, so you’ll want some gold in smaller quantities, as well as silver.

2. Make Volatility Work for You, not Against You

Market volatility can be a problem. It’s always a shame to see your stop loss trigger on a stock only to watch shares move to new highs. But as much as volatility can prove a disappointment, it can also be your opportunity.

For instance, when markets reach a short-term peak, you can buy shares of the Volatility Index ETF (VXX).

Then, after a big pullback (and when volatility bumps up) sell the shares.

It’s the market equivalent of “Lather, rinse, repeat.”

Let it work for you.

And playing volatility actually works much better with options.

After a big up day in the market, take advantage of significantly lower prices on put options. This is a good time to buy cheap “market insurance.”

And on a down day, buy calls in some stocks likely to pop when things turn around.

You’re essentially timing the options market to take advantage of the recent up/down, yo-yo-like movements.

Using this options strategy, sovereign investors can take advantage of the stock market even during wild times, while holding steady in mostly cash, gold, and “core” stock holdings.

No muscling through stressful, choppy markets. You can stand on the sidelines, and play at the same time with limited investment (and limited risk).

Best of all, this strategy will even allow you to eke out a profit when markets are flat, at best, and down, at the worst.

3. This Too Shall Pass (In the Long Term) …

The best way to use this strategy is to do your research and prepare for the long-term.

Market pullbacks are the best time for stepping back and taking a look at companies worth owning for the long term, and deciding at what price they’re worth buying.

The price will depend on the company’s past trading pattern. Your price point can depend on many things, such as a P/E ratio that’s at the bottom of the company’s historic range, or if the yield is higher than it tends to be (like grabbing a 4% yield on a stock that usually has a price with a corresponding yield of 3%).

For example, in March 2009, I picked up shares of Unilever (UN) at a higher yield than the company had been offering in the five years prior. Since markets were at their low point, but pessimism was still priced in, grabbing a higher-than-average yield on a defensive consumer staples company when interest rates were near zero was a great buying point. It still is.

With most of your money on the sidelines, it will be easier to be objective when deciding what’s worth investing in, and what’s not.

Long-term investments are no place for speculative, start-up companies.

Instead, focus on those companies with a long history of rewarding shareholders via dividend growth, strong branding power, and great management.

It sounds simple, but in reality, it’s one of the hardest things to do right in investing.

Focusing on long-term investments when the market is correcting can greatly impact your future returns… if you’re willing to sit tight and get in at a decent price.

So: stay defensive, stay safe, and stay sovereign!

Andrew Packer
Managing Editor, The Sovereign Individual