With The Stock Market Appearing Vulnerable, Focus on Protection of Capital

The S&P 500 Index has climbed more than 60% since the March low. Stocks seem more vulnerable after this surge and in view of the highly uncertain, in fact, rather cautious economic outlook. Protection of capital is always the first investment priority, as I lay out in Full of Bull, but it is of paramount importance now given the valuations of many stocks. Extremely low interest rates, heavy government induced liquidity, and vast amounts of capital on the sidelines have aided the stock market during the last eight months. But there is likely to be unusual stock market activity in December and January, as institutions such as mutual funds and hedge funds lock in profits and decrease equity exposure at the outset of the new year. Focus on preserving your capital in advance. December–January will be a good period to stand back, be cautious, and avoid exposure to a potential market contraction.

Recently, there was surprisingly disappointing economic news regarding a more than 10% decline in new housing starts in October. Over 12% of U.S. households with mortgages--almost 7 million--have payments in arrears or are in the foreclosure process. A further potential tidal wave of  foreclosures may be coming in 2010-2011. Unemployment is well over 10% and still rising, so consumer spending will be curtailed for years. The next major down draft is likely to be in commercial real estate, with office vacancies now above 17%, and $3.4 trillion in related debt outstanding, much of it underwater.  Deflation is wide spread and may be followed by stagflation. Federal debt has surged and taxes will be heading higher. It looks like any economic recovery will be L-shaped. This scenario puts a damper on stock market prospects and corporate earnings growth in 2010.

Protection of capital is an investment objective far ahead of gains and returns. The magnitude of gains is almost irrelevant compared to the preservation of your investment pool. If you doubt me, just ask anyone who watched their nest egg evaporate when the 1990s bubble burst, or dive 40% to 50%, along with their home equity, amidst the 2007-2009 bear market meltdown. After a 50% drop in a stock, it requires a 100% rise in the price to get back to even. It is of less consequence if a stock rises 10% or 50%, but it is a major disaster if it declines 30%. Many investors lost as much as 50% of their capital in the 2007-2009 bear market. Their investments have subsequently rallied along with the entire market perhaps by more than 50%. Guess what? They are still far from being back to even, actually still requiring another gain of similar magnitude  just to reach break even. A tall order. So always be conservative, and think in terms of downside potential and risk.

The point here is don’t lose. That is the secret of superior investing. Charles D. Ellis makes the point in a Financial Analysts Journal article: “large losses are forever—in investing, teenage driving, and fidelity…and are almost always caused by trying to get too much by taking too much risk.” He discusses the excitement of “the big score,” which causes the investor to put too much emphasis on offense, with little regard to defense. The greatest impediment to proper investing is underestimating risk.

Brokerage firms are extremely favorably biased. Street research analysts rarely indicate the worst-case downside risk in a stock, only the upside price objective. Funny how you never see a downside stock price risk potential in a research report. I recently noticed in a particular report that only 2% of all the firm’s stock opinions were Sells. As of November 1^st , only 7% of all analyst opinions in North America were Sell ratings, according to Thompson Financial. Quite a story appeared in the press in November about a Jeffries analyst who was brilliantly accurate with a high profile Sell recommendation but came under such pressure from vested interests he was compelled to leave the firm. Brokerage firms never care about preserving your capital and they rarely focus on helping you to avoid losing money. Wall Street pays little attention to its own risk profile, as evident in the 2007-2008 debacle when firms like Lehmann Brothers, Bear Stearns and Merrill Lynch capitulated due to holdings of toxic assets such as subprime loans and collateralized debt obligations.

In light of the stock market run up, investors seem to be paying less attention to risk and capital preservation. It is time to make this the highest priority. If 50% of your portfolio is in stocks, it should probably be eased back to 25%. The stocks that you hold on a long term basis should carry healthy dividends and a good yield. A safe dividend provides more downside protection than non-dividend growth stocks. Dividend payers also outperform non-payers in bull markets. Since 1926 some 43% of the total stock market return has stemmed from dividends, 39% since 2003. Dividends are always important but even more critical in helping protect capital in periods like right now.

The weak dollar outlook, astronomic federal deficits, and the need to help protect your capital in my view also cries for an investment position in gold, via an exchange traded fund (ETF) or some other avenue. India, China, Russia and other countries are buying gold as a hedge against the weak dollar currency. Gold is an effective store of value, especially in view of all the issues on the 2010 horizon, and it deserves a place in any portfolio with an objective of protecting value.

Do not wait until year end or January to reposition your investments in line with the objective of preserving your capital. Given the uncertain times that the market faces in 2010, the professional insiders will be scurrying as the new year beckons. You need to get ahead of them and make your repositioning moves early.