Association for Investor Awareness - Week of 04/29/2010

Special Report

Protect Your Stocks From A Correction

In This Issue:

A Stock Market Downturn Is Overdue
Stop-Loss Orders Can Save A Portfolio
Safeguard Your Blue Chips With LEAPS
Some Funds Go Up During Downturns
We Don't Recommend Short Sales
An All-Weather Fund For Cautious Investors
The Bottom Line This Week

Since the bull market started last March 9, the stock market has been on a tear. For the 13 month period, the Dow rose 68.7% and the Nasdaq shot ahead 94.8%. After the unpleasant losses investors endured from late 2007 to early 2009, the rebound was especially sweet.

Although we think the bull market has further to go, we also think the near-term downside risks are becoming significant. Consequently, we are devoting this issue of the AIA Advocate to strategies that you can use to protect your portfolio while remaining invested for whatever additional profits are on the way.

A Stock Market Downturn Is Overdue

With the Dow now over the long-awaited 11,000 mark, nearly everyone on Wall Street is singing "Happy Days Are Here Again." One aggressive broker we heard about has the tune run softly in the background when he talks with his clients "to create the proper atmosphere."

Wall Street's army of cheerleaders aside, after its year-long run, a stock correction appears to be overdue, and it may be quite sharp.

However, there is so much money chasing stocks the run could also continue for quite awhile. If you cash out prematurely, you will miss out on any future gains – and they could be substantial. So what is a prudent investor to do?

Stop-Loss Orders Can Save A Portfolio

Fortunately there are several ways to stay in the stock market with reasonable safety. One of the best methods to protect your portfolio is to put stop-loss orders on everything.

Stops, as they are often called, are sell orders you place with your broker to be used only if your stock should decline to whatever safety level you chose. The orders cost nothing unless they are needed. They remain quietly in the background ready to pounce if your stocks start to slide.

To place a stop-loss order, simply pick a price you would like to get for your stock if it starts to move down. If the stock reaches your level, you will either get your price, or come close to it. Just be careful to pick a price that is outside the stock's normal trading range so it won't be sold prematurely.

There are three forms of stop-loss orders. A "stop market" order will be executed at the best price your broker's automated system can get if a stock falls to the point you specify. However, if the market declines quickly, your order might not be executed until the stock is below the level you picked. Nevertheless, you will be taken out long before most investors even know there is a problem.

A "stop limit" order works the same way, except your stock can only be sold at the exact price you specify. In most cases, stop limit orders work just fine. However, if it is not possible to get your price you won't be protected.

We think the finest protection of all are "trailing stops" that automatically move up as a stock rises. You can specify a percentage of the stock's price you wish to maintain, or you can choose a specific number of points. Either way, if the stock falls to your trailing stop, it will be sold automatically at the best available price.

Stop-loss orders have another big advantage investors don't usually notice until they start using them. Stops eliminate the need to make sell decisions when prices are falling, a task most investors don't do very well. Stop-loss orders make selling automatic, and painless.   

Safeguard Your Blue Chips With LEAPS

LEAPS options can also be used to protect stocks that you think will go up in value, but could drop sharply if market conditions deteriorate. For such a stock, you could buy one downside LEAP option (called a LEAP Put) for every 100 shares you own.

If the stock falls to your strike price, or below, the profits you will make from the LEAP can offset your loss in the stock. If the stock rises instead, your LEAP will expire worthless. However, the loss from the LEAP won't prevent you from ending up with a nice profit if the stock goes up significantly.

LEAPS offer a simple and economical way to protect profits in a late bull market without selling the stock before the rally is over. We think LEAPS are very attractive right now and should be more widely used. They are available for nearly all blue chips traded in the U.S.

Some Funds Go Up During Downturns

There is another way to get some downside insurance at the same time you remain invested in the stock market for possible longer term growth. Two bear market mutual funds are designed to go up if the market sinks.

The Rydex Inverse S&P Strategy Fund (RYURX) offers broad protection against a stock market decline. The fund is structured to move inversely with the S&P 500 index. The counter-cyclical action is achieved through the use of put options, short-sales, stock index futures and related strategies.

The ProFunds UltraBear Inverse Fund (URPIX) works the same way, but it is much more aggressive. UltraBear also acts inversely to the S&P 500 - but it seeks to double the size of the moves. The fund uses the same investment vehicles as Rydex, but its managers purchase more of everything to gain the extra leverage.

Of course, the lever swings both ways: The bear market funds will decline quickly if the S&P 500 index rises. As a result, they are best used during uncertain times when the market could go either way, which seems to be the situation now. Once the break occurs, investors close out the losing position and let the winner run.

We Don't Recommend Short Sales

Some investors may wonder why we don't just sell weak stocks short, a strategy in which shares are borrowed from a broker and sold. The goal is to someday replace the borrowed stock at a lower price and pocket the difference.

The reason we don't make short sales, is very simple: the payoffs they offer rarely justify the risks they carry. Here's why:

When you buy a stock it can go up 100%, 200%, or more. There is no limit. In fact, investors who purchase high quality stocks, and hold them for many years, will often see breathtaking gains. Due to the power of compounding, many investors who appeared to be making only modest gains from their 30s to their 50s can suddenly find they are very wealthy by the time they reach 65.

With a short sale, however, the most a stock can do is drop to zero. That limits the potential return to a puny 100%. There aren't any three and four baggers, or more, with short sales.

On the other hand, there is no limit to the amount of money you can lose in a short sale if the stock turns around and goes up. Since you must eventually buy the stock to replace the shares you sold short, the pain could be extreme.

An All-Weather Fund For Cautious Investors

If you are tired of worrying about market reversals and how to deal with them, you may wish to consider putting some money into a good all-weather fund. We think the best of the lot is the Permanent Portfolio Fund (PRPFX).

As can be seen in its price chart, the fund rarely does as well as the stock market during booms, but it almost never does as badly during downturns. Instead, the fund seeks a happy medium and generates attractive long-term gains without taking undue risks.

The Permanent Portfolio Fund achieves its goals by investing primarily in precious metals, hard currencies, Swiss Confederation bonds, high grade corporate bonds, and stocks of leading energy and industrial material suppliers.

Although the fund sticks to a limited range of assets, the balance between them changes to suit the economic and investment outlook. The fund is currently configured to profit from rising inflation and a declining dollar. We think that strategy will pay off handsomely over the next few years.

The Bottom Line

After over a year of nearly unbroken gains, the stock market seems overdue for a correction. Since it has been awhile since the last one occurred, when the drop comes it may be larger than we usually see.

Investors who don't want to run the stock market rapids, but don't want to sell prematurely, can have their cake and eat it too with stop loss orders, LEAPS, and bear market funds. Among the latter we like the Rydex Inverse S&P Strategy Fund that performs well when the market drops. More aggressive investors should consider ProFunds UltraBear Inverse Fund.

Alternately, investors can put their money into an all-weather fund such as Permanent Portfolio Fund. It has an excellent long-term track record for delivering gains without pains. 

Until Next Time

The AIA "Advocate For Absolute Returns", a publication of The Association for Investor Awareness, Inc., tracks market trends, industry news, the SEC, global trade and finance and Washington developments for you because they affect your investments. But who doesn't? Many sources report these issues as abstract facts. We feel that's not enough. The AIA Advocate's job is to warn you of what's important and how these developments translate to ground-level forces and threats that directly affect your wealth as well as your current investment opportunities. Not just information, but information you can use. Until next time...


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Posted 04-29-2010 3:11 PM by Research & Editorial Staff