By Stephen Schurr –
It is deep January. The sky is hard. The stalks are firmly rooted in ice.
To the bearish investor, market barometers are rarely given much credence – until they start giving off bear signals.
January is a fertile month for market yardsticks, with the most prominent being the January Barometer. This gauge, popularised by the Stock Trader’s Almanac, posits that as the first month of the year goes, so goes the year. While no barometer is fail safe, the January Barometer has worked better than many and when the month is down, it serves as a warning for investors. Nineteen of the 20 down Januarys since 1950 were followed by full-year declines of 13 per cent on average, according to the Stock Trader’s Almanac (1982’s bleak January augured a miserable first half of the year, followed by the start to the epic bull market of 1982-1999, RIP).
The market in 2005 isn’t off to the most auspicious start, with the Dow Jones Industrial Average and the S&P 500 off 3.6 per cent through last week and the Nasdaq Composite off 6.5 per cent. Of course, the markets may rally for the remainder of the month, putting the measures in positive territory. If they do not, it is quite possible that the January Barometer is giving off a false signal or is simply broken – market barometers don’t work so well once every one anticipates them and manoeuvres early to take advantage of them.
While I suspect the January Barometer will lend support to my viewpoint, it won’t change my opinion either way. As readers of the Hands-On Investor column know, I hold a bearish outlook for the markets in 2005. Whatever the barometer shows, it will not change the fact that interest rates and inflation are rising, earnings are near their cyclical peak, many industries still suffer from overcapacity and the US consumer is exhausted and overextended. Valuations, particularly in the technology sector, do not reflect these points.
Whether readers choose to focus on the above laundry list or the January Barometer does not matter too much to me. What matters is that hands-on investors take a close look at their portfolio, now that the 2½-year rally from 2002 lows looks long in the tooth, to determine if they need to inject a little more caution. While the common line in personal finance columns is “rebalance the portfolio at the end of the year and don’t come back again for another 12 months”, I advocate a less doctrinaire approach that adjusts for market realities, especially since the one-way market of 1982-1999 is history.
For an investor looking to position himself for a potential bear market, here are four ways to embrace the bear in 2005.
But first, I should caution against excessive measures: an investor can position his portfolio for a bear market, but one need not go overboard. The prudent investor should not time the market based on hunches, but rather adjust holdings to protect themselves against unfavourable possible outcomes. A 5-10 per cent position may do the trick for most; anything beyond 20-25 per cent approaches excess.
Buy Gold. Every investor should hold a 5 per cent stake in gold. First, it is the greatest insurance against catastrophe; whenever the world goes to pot, gold blossoms.
Second, in less extreme circumstances, gold offers pure diversification – it has been negatively correlated to the S&P 500 and the US long bond going back to 1968 and has almost no positive correlation with inflation, a big bug bear for 2005.
Third, after a two-decade bear market, gold’s prospects for the next five years remain bullish. With the metal fetching about $425 an ounce, it could easily hit $500 within the next 12 months.
A gold-averse investor no longer has the excuse that it is too difficult to get a piece of the precious metal in his portfolio. The new exchange-traded fund, StreetTracks Gold Trust, is the first commodity-pegged exchange traded fund (readers: pray for more) and trades on the New York Stock Exchange under the symbol GLD. If the ETF does not grab you, a solid mutual fund pick is First Eagle Gold.
Sell, Hedge or Short Technology. Despite the correction that has dragged tech shares from a 40 per cent weighting in the S&P 500 in March 2000 to a 16 per cent weighting today, the sector remains near the bottom of the barrel when it comes to quality. The dividend yield offered by the sector is scant, executive stock options will punish earnings when expensed properly, low-cost competition from emerging economies is fierce, inventories remain high and valuations are rich. Tech is my bet for weakest sector in 2005.
How should an investor protect himself? First, examine one’s tech exposure – accomplished via portfolio analysis tools on websites from the likes of Morningstar, Smart Money and Fidelity. At the very least, one should be underweight the S&P 500 weighting. The easiest way is to lighten up on tech-heavy positions, be they individual stocks or mutual funds. One can also hedge tech bets via options, buying puts against individual stocks.
Going a step further, an investor comfortable with a little more risk can short-sell a tech-focused index or ETF, such as the Nasdaq Composite or the iShares Goldman Sachs Semiconductor index ETF. However, given the volatility of the sector, a short-inclined investor should be braced for sharp movements in both directions.
Buy Energy. Energy was the best performing S&P 500 sector in 2004, returning 28.8 per cent and it has held up so far in 2005, easing a mere 0.4 per cent. The outlook for energy stocks remains bright, thanks to soaring demand from the US, China, India and elsewhere, and supply constraints. Even with the recent strength, most energy stocks do not reflect the new normal: oil prices in the mid-$30s a barrel at the low end.
Investors have plenty of fine ETF choices, including the Oil Service HOLDRS and the iShares S&P Global Energy Sector Index fund. My favourite energy fund, the low-cost Vanguard Energy fund, recently closed to new investments. Jennison Natural Resources and the T. Rowe Price New Era funds are worthy choices.
Buy Canada. What are the ingredients for a perfect bear-case investment in 2005? It would be an asset class that has lower correlation with the US but is not a volatile emerging market; and it would also be reasonably valued, rich in natural resources plays while light on technology and rate-sensitive financial stocks. The one investment that offers all these options is Canada, and the best way to get a passport north is the iShares MSCI Canada index fund.
Source: Financial Times