The Economic Climate (12): The UNPREDICTABLE Economic Climate and the Investor

From the Great Depression to 1995, US had nine recessions.  So in your lifetime, you're likely to be subjected to a dozen or more. 

Each time it happens, you'll hear from the reporters and the TV commentators that the country is falling apart and that owning stocks is too risky. 

The thing to remember is that we've wiggled out of every recession since the one that turned into the Great Depression.

Reviewing the period from the Great Depressions to 1995 shows that

• the average recession lasts 11 months and 1.62 million jobs are lost, while
• the average recovery lasts 50 months and 9.24 million jobs are created.

The seasoned investor realizes that stock prices may drop

• in anticipation of a recession, or because
• Wall Street is worried about inflation

But there's no sense in trying to anticipate either predicament, because the economic climate is unpredictable. 

You have to have faith that inflation will cool down eventually, and that recessions will thaw out.

Why Now's the Time to Get Defensive

Why Now's the Time to Get Defensive
By Todd Wenning
January 13, 2010

Do you hear that?

 

To steal a phrase from Simon and Garfunkel, it's the sound of silence in the market. And it's making me nervous.

 

Remember just 12 months ago, when the CBOE Volatility Index, the "VIX," was comfortably over 40, implying significant investor uncertainty? Those were indeed scary times, a few months after Lehman Brothers collapsed in September 2008, but as an investor I was actually more comfortable then than I am right now. There were a lot of great stocks on sale!

 

You haven't heard about the "VIX" for a while now because, guess what, it's back below 20 -- implying investor complacency. We haven't been this low since (gulp!) August 2008, before the Lehman Brothers debacle.

 

Scared yet?
Even though the stock market has charted a steady upward course since last March, I have a hard time believing that all is well enough in the global economy to justify complacency.

 

That's why now is the time to get defensive. That means:

 

• Having cash available to invest.
• Considering options strategies to protect your gains.
• Building a watch list of stocks you'd want to buy at 10%-15% below current prices.

Traditional defensive maneuvers would typically include increasing your bond exposure, though with yields so low and interest rates inching higher, I don't think this is a great place to put new money right now.

 

My best friends call me "Cash"
Thanks to the government's policy of low interest rates and quantitative easing, there's been (by design) little reason to hold a lot of cash. That's helped fuel both the bond and stock markets, as investors looking for even a tiny profit needed to put their cash to work somewhere.

 

Still, cash isn't trash and there's simply no substitute for quickly seizing opportunities in the market. If you're 100% invested and the market loses value, you need to sell something (at a lower price, of course) before you can buy anything else. That's a tough position to be in when stock values become much more attractive.

 

In our Motley Fool Pro portfolio, for instance, we took advantage of last year's market downturn by using our cash to pick up solid companies like Intel (Nasdaq: INTC) and Autodesk (Nasdaq: ADSK) at very attractive prices. Today, we've strategically left a large cash balance in the portfolio to grab future bargains the market may throw our way.

 

Yes, you have options
Market volatility plays a major role in the pricing of options (calls and puts). This is because investors perceive "risk" as volatility and when volatility is low there's simply less demand from options buyers (who have the right to buy and sell a stock) who seek to improve returns with big moves in stock prices.

 

All of this is to say that when options prices are low and the market's been rallying, consider protective puts on stocks and exchange-traded funds that have made you big money.

 

Let's say you bought 100 shares of SPDR Gold Trust (GLD) ETF in November 2008 for $75 -- a $7,500 investment. The ETF currently trades for about $113 -- a nice 50% gain for you. By purchasing a March $110 put for $2.75, you can lock in a sales price of $110 for your 100 shares through March 19, 2010, for $275 per contract.

 

One scenario: The ETF doesn't fall below $110 by March 19 and you're out $275 (4% of your original investment). But hey, you can still enjoy any upside left in the ETF. The other scenario: The ETF falls well below $110, but you can still sell for $110 (minus the $2.75 per-share cost) thanks to the protective put you bought.

 

Think of buying protective puts on your big winners as insurance against the chance of losing those gains in a market downturn. Even though you may grumble when you pay the premium for the put, just as with your auto insurance, you'll be glad you did if something bad happens. At the very least, it can give you some peace of mind in an uncertain market.

 

Make a list, check it twice
U.S. stocks have made a huge recovery from their March 2009 lows, and while I don't think they're anywhere near bubble territory, good values have become harder to find. That doesn't mean you should stop researching, though.

 

Here are five S&P 500 stocks with returns on equity over 15%, price-to-free cash flow ratios below 20, and manageable debt levels -- in other words, strong companies worth buying if the market does take a downturn.

 

Company
Price-to-FCF
Return on Equity
Total Debt to Equity

 

Coach (NYSE: COH)
15.9
38.7%
1.37%

 

Gilead Sciences (Nasdaq: GILD)
16.0
49.4%
24.40%

 

Cisco Systems (Nasdaq: CSCO)
18.0
15.2%
25.70%

 

Stryker (NYSE: SYK)
18.3
17.7%
0.30%

 

Automatic Data Processing (NYSE: ADP)
17.1
25.4%
0.70%

 

 

Data provided by Capital IQ, as of Jan. 12, 2010.

 

 

Great companies don't always make great investments -- they still need to be bought at the right price.

 

Cisco Systems, for instance, has doubled its net income over the past decade, but remains 50% off its January 2000 prices. That's because investors were paying too dearly for Cisco's prospects during the dot-com bubble and, even though Cisco is a much better company today than it was in 2000, its 10-year stock chart doesn't reflect this progress.

 

That's why it's so critical to buy great companies only at the right prices. Another market dip could give us that opportunity, so prepare yourself now with a good watch list.

 

Get started now
When the market grows complacent, you need to get defensive -- no matter where you think it's going. It's only a matter of time before something spooks the herd and volatility once again ensues. By having adequate cash on hand to buy solid stocks at good prices and using options strategies to protect your gains, you can set yourself up for better long-term investment success.

 

That's our aim at Motley Fool Pro, where we use stocks, ETFs, and options to help investors make money in all types of markets. If you'd like to learn more about Pro, simply enter your email address in the box below.

 

http://www.fool.com/investing/general/2010/01/13/why-nows-the-time-to-get-defensive.aspx

Benjamin Graham felt that individual investors fell into two camps

Types of Investors

Graham felt that individual investors fell into two camps :

• "defensive" investors and
• "aggressive" or "enterprising" investors.

These two groups are distinguished not by the amount of risk they are willing to take, but rather by the amount of "intelligent effort" they are "willing and able to bring to bear on the task."

Thus, for instance, he included in the defensive investor category professionals (his example--a doctor) unable to devote much time to the process and young investors (his example--a sharp young executive interested in finance) who are as-yet unfamiliar and inexperienced with investing.

Graham felt that the defensive investor should confine his holdings to the shares of important companies with a long record of profitable operations and that are in strong financial condition. By "important," he meant one of substantial size and with a leading position in the industry, ranking among the first quarter or first third in size within its industry group.

Aggressive investors, Graham felt, could expand their universe substantially, but purchases should be attractively priced as established by intelligent analysis. He also suggested that aggressive investors avoid new issues.

http://www.investinvalue.com/0/styles.php

(Check out the table in this site for rules for defensive versus enterprising investors.)


Also read:
Investment Policies (Based on Benjamin Graham)

Investment Policies (Based on Benjamin Graham)

Summary of Investment Policies

A. INVESTMENT FOR FIXED INCOME:
US Savings Bonds (FDs or Amanah Sahams for Malaysians)

B. INVESTMENT FOR INCOME, MODERATE LONG-TERM APPRECIATION AND PROTECTION AGAINST INFLATION:
(1) INVESTMENT FUNDS bought at reasonable price.
(2) Diversified list of primary common stocks (BLUE CHIPS) bought at reasonable price.

C. INVESTMENT CHIEFLY FOR PROFIT: 4 approaches are open to both the small and the large investors:
(1) Representative common stocks bought when the MARKET level is clearly LOW.
(2) GROWTH STOCKS, when these can be obtained at reasonable prices in relation to actual accomplishment – GROWTH INVESTING.
(3) Purchase of securities selling well BELOW INTRINSIC VALUE – VALUE INVESTING.
(4) Purchase of WELL-SECURED PRIVILEGED SENIOR ISSUES (bonds and preferred shares).
(5) SPECIAL SITUATIONS: Mergers, arbitrages, cash pay-outs.

D. SPECULATION:
(1) Buying stock in new or virtually new ventures (IPOs) .
(2) TRADING in the market.
(3) Purchase of "GROWTH STOCKS" at GENEROUS PRICES.


_______________


For DEFENSIVE INVESTORS: Portfolio A & B
(Portfolio A: Cash, FDs, Bonds Portfolio B: Mutual funds, Blue chips)

For ENTERPRISING INVESTORS: Portfolio A & B & C
(Portfolio C: Buy in Low Market, Buy Growth stocks at fair value, Buy value stocks i.e. bargains, High grade bonds and preferred shares, Arbitrages)

For SPECULATORS: Portfolio D
(Should set aside a sum for this separate from their money in investing.)

________________
________________


Types of Investors

Graham felt that individual investors fell into two camps : "defensive" investors and "aggressive" or "enterprising" investors.

These two groups are distinguished not by the amount of risk they are willing to take, but rather by the amount of "intelligent effort" they are "willing and able to bring to bear on the task."

Thus, for instance, he included in the defensive investor category professionals (his example--a doctor) unable to devote much time to the process and young investors (his example--a sharp young executive interested in finance) who are as-yet unfamiliar and inexperienced with investing.

Graham felt that the defensive investor should confine his holdings to the shares of important companies with a long record of profitable operations and that are in strong financial condition. By "important," he meant one of substantial size and with a leading position in the industry, ranking among the first quarter or first third in size within its industry group.

Aggressive investors, Graham felt, could expand their universe substantially, but purchases should be attractively priced as established by intelligent analysis. He also suggested that aggressive investors avoid new issues.


Read also:
Are You an Intelligent Investor?

http://www.investinvalue.com/0/styles.php
(Check out the table in this site for rules for defensive versus enterprising investors.)