When nothing else is working, cash is king

Today's (June 15) fall of 179 points in the Dow continued a string of almost uninterrupted bad days for the equity market. The averages are approaching critical support levels and if the market drops further, there could be serious declines coming. At the risk of sounding immodest, I'd like to point out that I predicted this drop in the equity markets in an earlier post.

Before I get too cocky, I also suggested putting much of your portfolio into commodities including precious metals, and into international bond funds not pegged to the US Dollar. As it turns out, the world economic situation has changed and those are no longer good investments. The reason I'm backing off these recommendations is threefold:

(1) Economic growth is slowing more than expected so there is little upward pressure on commodities right now - that is forcing commodity stock prices down.

(2) Other economies around the world (Europe and Japan in particular) are in awful shape.Think of the US Dollar as the 110-pound weakling battling against the 98-pound (or 44.5 kilos) Euro and Yen and you get the picture. The Dollar is weak, but it's still better than other currency options.

(3) The bond market as a whole is walking on very thin ice right now. If countries start defaulting on bonds (as it looks more and more likely will happen), it will send interest rates up very fast. The interest rate on a 10-year Greek government bond is 18% today. If a few other governments start defaulting, the interest rate for government bonds around the world will skyrocket. That will make the face value of current US treasury bonds at their lowly 3% rates plummet.

To summarize, these investments are not working right now: stocks, US bonds, international bonds, emerging market stocks,gold and precious metals, commodities and currencies.

Here are the investments that are working: (insert cricket sounds here)

Nothing is working. Not only are there no investments that are rising, all investments at this point in time have the potential risk to drop by a significant amount.

That includes bonds. If you are in bonds, I would get the heck out, and soon. Don't listen to investment advisors - bonds are not the risk-free investment that they are promoted as. They may not fall as much as stocks, and yes, you will get back your principal if you hold the bond until the end of the term (as much as 30 years). But if a bond drops by 10% in face value, that means it will take you over three years at 3% interest to bet back to even.

If you must own equities, I would stick with big-name companies with lots of international exposure, very strong brand names and high dividends. Stick with names like Apple (AAPL), Nike (NKE), Johnson and Johnson (JNJ), IBM and Altria (MO). But I would look for a low entry point, and don't buy on days when the market is up. You will probably still lose a little money over the next six months with these stocks, but if I'm wrong and stocks go up you'll have some upside potential. And these stocks pay nice dividends.

Another group of equities I like right now are banks. They have been beat down tremendously. The market hates bank stocks right now - many banks are priced below tangible book value. That means if you add up all the tangible assets (good assets, not bad mortgages) the total market capitalization on the stock is less than the net value of the company. That is a real bargain. I like Wells Fargo because it is really down and is a well managed bank. WFC closed at $26.55 today - in 2008 and much of 2009, when banks all over the US were falling like dominoes, WFC was at $30 or more. Is the banking environment worse today than it was during those dark days? I don't think so. I also like Morgan Stanley (MS) that is also under book value, and Goldman Sachs (GS), which is slightly over book value.

I would steer clear of bad-news banks like Bank of America (BOA) and Citi (C) which I think may be in for a rough ride in coming months.

Follow a plan, but not blindly

On April 3, I suggested a mixed portfolio of blue chip stocks, commodities, precious metals and international bonds as the best approach going into the summer. Immediately after that posting, I started a leisurely shift to that portfolio mix. As you may be aware, the market threw a curveball regarding commodities and precious metals. Commodities started to lose steam soon after my April 3 entry and precious metals continued their meteoric rise through most of April, until taking a pretty big dive the last couple days of April and the first week of May.

How did my portfolio do from April 3 until today? I'm pleased to say it is up about 1.7% over that period, thanks mostly to the incredible rise of silver and  good timing on my part to get out of SLV a couple of days before its collapse. I sold SLV (the silver ETF) when it dipped from $47 to $45 per share. A few days later it plummeted to $33.71 and is currently $35.64.

Should this volatility affect sticking to my plan? No, no, no! But like any plan, you must build some flexibility into it. An investment plan should NEVER be blindly followed - that is the road to ruin. Look at your investments at least once each week. Pay attention to the financial news. Silver rose too far too fast. When something looks too good to be true, whether in investing or anything else, it is more than likely a bubble. And bubbles are the land mines of today's investing world.

Having said that, I think the bubble has popped and silver is a buy at $35. In fact I got back into it today.

Commodities have performed very poorly the past month, they were a drag on my portfolio. Like precious metals, commodities also seem to be bouncing back.

With the bubble popped in precious metals and commodities down to more affordable levels, now is the time to structure your portfolio to the summer portfolio I recommended on April 3. I still think there is trouble on the horizon (look at the news on Greece today, for example) and the suggested portfolio is your best bet to not only avoid losses, but to make some gains in what I predict will be a negative stock market for the next six months.

The two things to remember when making any investment

It doesn’t matter whether it’s stocks, bonds, real estate, precious metals or any other investment – before you make a move, ask yourself these two questions:

What is your purpose (or goal)? In other words, why are you making this investment and what do you expect from it? This is a great way to cross-check your decision-making. For instance, are you are looking for a quick strike, to make 10% in the month or couple of months? If so, then buying Microsoft (MSFT) isn’t a good idea. It would take an earth shattering event to move the needle to the extent needed for a 10% pop in MSFT. But if your goal is a decent dividend with a chance for an OK gain in the next 6-12 months then MSFT might be the right choice for you.

It’s easy to get sucked in by the news of the day and buy stocks that are hot at the moment. If your goals are short term gain and you’re an active investor then that’s OK. But buying the “stock du jour” that is being touted on CNBC when your plan is to hold it in your IRA for the next 5 years that you pay attention to every 6 months is a recipe for disaster. In today’s world, a stock that is shining today could be a complete mess in just a couple of months.

What is the time frame? Ask yourself how soon you expect to be out of this particular investment. Lots of people (me included) invested in real estate six or seven years ago with the assumption that real estate would be much more of a liquid investment than it turned out to be. Those people who expected to be in and out of a real estate deal in 6 months or even 24 months found out the hard way that you need to put careful thought into your time frame.

The same thing applies to stocks or bonds – your time frame should play a major factor in your decision making. For example, you should treat your retirement portfolio much differently than your kid’s college fund. You may think that’s an oversimplification but I’ve seen people pack their kid’s college fund with high-flying speculative stocks and then be in utter shock when the kid’s portfolio takes a 30% haircut over a few weeks. That doesn’t mean you should forego stocks for a kid’s college fund, but that the stocks need to match the investment purpose.

Successful investing takes self-discipline and a big way to introduce that discipline into your investing is to keep in mind your purpose and timeline for each trade you make.

Beware of Zombie Stocks

I just noticed something and every time I see this occur, it baffles me why people do this.

Today is April 7. Blockbuster (the movie rental company) finally gave up a couple of months ago and put up its assets for liquidation. In fact this past week, Dish Network bought the assets of Blockbuster, Inc. for a small fraction of their original value.

The stock of Blockbuster Inc. is still trading. In fact it went up over 7% today. Before you get too excited, the stock increased $0.0048, less than a half a cent. However, on a stock that is selling for 6 cents, that is a 7% increase.

My wonderment comes at how anyone in their right mind would buy stock in a company that has no assets and is completely worthless. And trust me, I'm right to say Blockbuster Inc. is worthless - it is worth zip, zero, notta. So why are people buying this stock?

One answer is that buyers are carrying out speculation of the very short-term variety. But unfortunately, I think some people are buying Blockbuster because they don't understand that it is a "zombie company." The corporate Blockbuster is dead but still stumbling around for awhile until someone mercifully puts a bullet through its head. When that day happens (it will probably occur at the close of the asset sale to Dish Network) Blockbuster stock will officially be where it belongs, at zero. And this perverse game of musical chairs will certainly end with some poor idiots holding worthless Blockbuster stock.

How can I be so sure of this? It happened with GM not that long ago. The "old GM" stock continued to trade robustly for months after the decent assets were passed to the "new GM." Then one day, I see questions being posted on novice stock message boards, "What happened to my GM stock? When will I get my shares in the new GM?" Sorry, that didn't happen and everyone who was following the story knew the old GM was a zombie stock and had been for months.

Why the SEC allows zombie stocks to trade is beyond me. But since the government won't protect you from the "zombie menace" you need to protect yourself and stay away from these disasters.

The faster they rise, the harder they fall

I realize I butchered the original saying in the headline, but the original saying doesn't quite fit the point of this installment...which is, beware of high flying stocks when they run out of gas because they can go down - and they can go down fast.

Don't get me wrong - I love high flying stocks. In the past several months I have owned Netflix (NFLX, up close to 300% over the past year), Baidu (BIDU, up about 240% in the past year), Potash (POT, up 100% in the past eight months), and Freeport McMoran (FCX, about double since last June).

High flyers are a great way to make good money in a portfolio, but they hold some hazards as well. At some point, the fast gains made by these stocks push them far beyond a price that makes any rational sense. Does the word "bubble" bring back bad memories? High flyer stocks can eventually become one-stock bubbles just waiting for a chance to "pop and drop." That spells bad news if you aren't paying attention or refuse to believe there is an end to the dream. When a high flying stock falls out of bed, it falls hard - if you were late getting in on the stock, you can see all your gains disappear and end up with a loss in a matter of days.

I just had that experience with Netflix. This has been a great stock for the past year or more and the story is compelling. However, anyone will tell you that the stock is way, way overbought and the price is much too high. In fact, one Wall Street analyst has been telling anyone that will listen that the $234/share NFLX stock is logically worth about $70/share. I was late getting in, but finally bought some Netflix awhile back and made a quick 15% gain. But after I had it a few weeks, I started to get nervous. Having gotten in so late is a dangerous game to play, and the stock market hit a tiny bump and in two days my 15% gain was cut in half. I got out at that point and took my 8% gain.

If you want to play in the high flyer stock category, here are some things to remember: (a) Try to get in as early in the rise as you can, (b) Pay close attention to the stock. Don't expect it to go up every single day and think the sky is falling if it has a small drop now and then but don't let it ride indefinitely, (c) Get out, at least partially, if you think the sky is about to fall.

Regarding getting out partially, that is  a pretty useful strategy to keep in mind. Let's take NFLX as an example, and assume you were astute enough to buy 30 shares a year ago at $84 (an investment of $2,520). By January, 2011 the stock was $184. So you would have been up $100 per share. You want to hedge your bet a little bit, so let's say in January you sold 15 shares at $184 for $2,760). You have already guaranteed yourself a profit of $240, which is about 9%. That's a darn good rate of return for a year, you wouldn't make that in 5 years on a CD. But you also still have 15 shares of NFLX left. Move forward to April, 2011 - NFLX is now $234 and looking like it could be running out of steam. You are definitely in a great position - you can sell off more shares, let's say 10 more shares for $2,340. Now your guaranteed return is about 100%, you have doubled your money. Plus you still have 5 shares of NFLX valued currently at $1,170. At this point, Netflix could go the way of Blockbuster and you would still have doubled your money. But chances are that won't happen.

In essence, the concept above lets you play with the "house's money" instead of your own. It removes much of the risk of investing in high flying stocks. Yes, you do lose some potential gain by hedging your risk, but you have bought yourself some excellent insurance.

Investment Outlook for the Remainder of 2011

In my previous installment I played Chicken Little and warned that the US stock market was in for a rough stretch, probably starting in May and continuing through most of 2011. In an attempt to be part of the solution and not part of the problem, this installment features some ideas on where you might do well in the remainder of 2011.

Personally, I think it is a bad idea to be in US stocks for the remainder of 2011. If you’ve been in the market since January 1, you’ve done pretty darn well. It’s time to protect those gains and play defense.

Stocks

If you feel compelled to remain invested in the US stock market, it would be best to stick with two main groups of stocks: (a) commodities, energy, agriculture and raw materials; and (b) blue chip companies with ultra-strong international brands and good dividends, ideally higher up in the supply chain or with well-developed vertical channel influence.

For the first group, think about FCX (Freeport-McMoran), RIO (Rio Tinto), CLF (Cliffs Natural Resources), AA (Alcoa), CAT (Caterpillar) and POT (Potash). Inflation is bound to become an issue starting mid-year and commodities are at the top of the supply chain. Agriculture is also a good bet even though it’s a bit overbought right now. I would also use stocks to trade into gold (symbol GLD is an ETF for that purpose) or silver using the ETF symbol SLV.

For the second group, some good candidates include JNJ (Johnson and Johnson), IBM (IBM), Nike (NKE), Google (GOOG), and MSFT (Microsoft). Other than Google, those stocks pay pretty good dividends and other than Nike are not impacted by inflation.

Bonds

What about bonds? Not very good news there either. When QE2 ends this summer, there is going to be hell to pay in the short term bond market. Think of it this way – right now the Fed is competing with China and other debtors to buy Treasuries and that is holding interest rates artificially low. When that Fed-induced competition goes away at the end of QE2, watch interest rates rise. You do not want to be caught holding Dollar-based bonds of any sort when that happens, but especially not in Treasuries. One of the biggest buyers of Treasuries, PIMCO, has already announced their intention not to buy any more Treasuries for a while.

Since interest rates will rise, bonds are very dangerous territory to be in. However, international bonds should provide a safe haven of sorts. Yes, they may take a small hit due to rising rates in the US. However, it won't be nearly as bad as US bonds, and being in foreign bonds also gets you out of the US Dollar at the end of QE2. Avoiding exposure to the US Dollar is a good idea come the end of June.

A portfolio idea

My personal plan is to be invested roughly as follows for the rest of 2011. I’m in the process of allocating in this direction right now, with completion around May 1: 15% US stocks of the blue-chip variety I described earlier, 20% stocks in the commodity/agriculture/raw material area, 15% between the SLV and GLD ETF's mentioned above, 35% in international bond funds (completely out of the US Dollar with focus on emerging markets, I am using the SPDR Barclay IBND and EBND symbol ETF’s but looking to diversify on those as well) and the 15% remaining in capital preservation-type accounts. I’m actually a bit worried about having that last 15% in money markets as those rely on short term Treasuries, and I may move that last 15% into non-Dollar based bond funds.

This is one person's opinion. Who knows if I am right? As the dog days of summer come and go, check back here. I'll either be eating crow or crowing about avoiding losses and even making a few bucks.

Look out for the “May is time to go away” effect in 2011

There’s an old saying among stock investors that says to invest “November to May then go away.” Traditionally, the return on stocks between November and April is significantly higher than returns in May through October. Obviously not everyone follows this advice - if everyone tried to take advantage of this then it wouldn’t work. And like all predictors of stock prices, the November-to-May system is wrong on enough occasions to dissuade people from going “all in” each and every year.

Having said that, I firmly believe that May, 2011 is the perfect time to “go away” from the stock market for several months. Here are some reasons why:

- The Federal Reserve’s QE2 program officially concludes at the end of June, 2011. The economy, while anything but robust, is showing enough signs of life that the Fed is very unlikely to extend Quantitative Easing into a third phase. The end of QE is going to have significant effect on interest rates (going higher) since the Fed will not be buying up Treasuries like drunken sailors. Instead real buyers, like China, will have to take up the slack and those buyers are not showing a lot of confidence in Uncle Sam these days.

- The stock market is overbought right now. Sorry, I don’t care if the historical PE isn’t quite at bubble level yet and that corporate earnings are strong. The US economy is not as strong as many people would like to think – just look at unemployment and the housing market as exhibits A and B. Current corporate profits have been made by two years of cost cutting – now companies are going to have to rely on top line growth and that isn’t going to happen with $4 gas prices.

- The strong market we’ve had can’t continue. Look at all the bad news that the market has virtually ignored while it soared to the best performance in March since 1998.  Japan, the economic issues that continue to mount in Europe, the fact that Uncle Sam hasn’t the willpower to cut spending or raise taxes, and the unrest in the Middle East. A market that soars contrary to horrible things going on all around it is heading for a fall.

As with any other financial advice, you should take whatever I say for what you think it’s worth. But all evidence is pointing toward a correction – perhaps a really big one – around late spring to mid-summer.

If stocks aren’t a good investment for the next 6 months, what is? Look for the next blog.