3 Ways to Prepare for the Next Big Drop

3 Ways to Prepare for the Next Big Drop
By Dan Caplinger
January 19, 2010 | Comments (0)

This time last year, even a dart-throwing monkey could have made money in the stock market -- all you needed was the courage to buy at one of the scariest times in history. Now, though, financial markets of all sorts have risen sharply, and there's a lot more to making a winning investment than picking a stock ticker at random and buying shares.

It's a whole new ball game
If you're like many people, you've probably done your best to repress your memories of early 2009. Back then, the stock market was falling apart, after a failed attempt to put together a rally off the lows set during 2008's panic. Everyone was convinced that companies like MGM Mirage (NYSE: MGM) and Bank of America (NYSE: BAC) were just a few steps from bankruptcy, and even the prospects for healthier companies seemed grim.

Now, though, fear has given way to greed. Many of the stocks that seemed most likely to fail instead topped the performance charts for 2009. Stock markets around the world saw huge gains, with the U.S. market's rise relatively small in comparison to jumps in emerging markets like Brazil and China. Moreover, after a terrible end in 2008, commodities also regained much of their lost luster, as gold jumped to new highs and energy prices made a sharp recovery from their huge drop to $30 from nearly $150.

If those big gains make you nervous, you're not alone. If you think it's time for these roller-coaster markets to start another downswing and don't want to go along for the ride, then here are three things to think about for various parts of your portfolio.

1. With stocks, think quality
Amid all the big gains of last year, many stocks have gotten left behind, at least compared to the overall market. Johnson & Johnson (NYSE: JNJ), Procter & Gamble (NYSE: PG), and AT&T (NYSE: T) are among the big-name companies that haven't seen anything close to the gains of even the S&P 500, let alone the multibagger performance that dozens of stocks produced last year.

But there are two reasons to look for lagging sectors. First, as bull markets evolve, they tend to go through sector rotation, in which stocks that haven't performed as well catch up with the top performers. So if this is the beginning of a longer-term bull market, then you can expect large caps that have thus far been left behind to see some gains.

On the other hand, the stocks that have risen the most also have the furthest to fall. If the stock market's rally reverses itself soon, then you can expect stocks that are still value-priced to hold up better than highfliers without the fundamentals to back up their lofty valuations.

2. With bonds, think duration
Everyone's stretching for yield right now, as interest rates have remained low. When you need income from your portfolio to survive, times like these can lead you to take desperate measures.

But you need to resist the urge to buy longer-term bonds just to get higher yields. Rates show signs of rising soon, and if they do, falling prices could wipe out the higher interest you'll receive on long bonds. In contrast, short-term bonds won't pay as much income up front, but they also won't lose as much value per percentage-point move in a rising-rate environment.

Finally, just as speculative stocks may have gotten ahead of themselves, lower-quality corporate bonds have also jumped in front of Treasuries. Consider rebalancing your portfolio to get its risk profile back where you want it.

3. With alternative investments, be wary
Commodities and real estate are becoming more mainstream investments than ever. But while having some exposure can help your portfolio, now isn't the time to make huge bets on them.

Whether you use stocks like Freeport-McMoRan Copper & Gold (NYSE: FCX) and Precision Drilling Trust (NYSE: PDS) as proxies for metals and energy or invest in specialized ETFs with direct exposure to commodities, prices have jumped a lot over the past year. Hedging your holdings, either by selling some of those investments or with other strategies such as writing covered calls or buying puts, can take some risk off the table.

Watch your greed
Most investors are in much better shape now than they were this time last year. But you don't want to lose those hard-fought gains. By taking steps to secure your portfolio, you'll help to keep yourself from enduring the same trials you suffered through during the financial crisis.

With so many stocks seeing big gains, focusing on value stocks might seem hopelessly outdated. Jordan DiPietro takes a closer look at whether value investing is dead.

http://www.fool.com/retirement/general/2010/01/19/3-ways-to-prepare-for-the-next-big-drop.aspx