A five-step plan for protection and profit in an unstable market
In the face of a market correction, this analyst unveils a plan designed for maximum returns, complete with recommended ETFs and stocks.
“North American markets are close to becoming fully valued.”
Those lines were written as stock markets were beginning to lose momentum.
They have been lurching along ever since, although the TSX has shown some promise with a two-day rally.
Nonetheless, Mr. Keith Richards, author of our opening statement, makes a point that no investor can ignore.
Potential investment risk has begun to outweigh potential investment reward. It is high time to protect yourself, writes this seasoned portfolio manager in one of his regular updates in Investor's Digest of Canada.
Before the trouble started, Mr. Richards and his team had already constructed a five-step plan designed to combat a market correction.
This strategic plan “fortifies portfolios against a potential financial shock,” he writes, “while helping investors profit from a market sell-off’s destructive tremors.”
It also gives investors specific choices, detailing several exchange-traded funds (ETFs) and individual stocks used to fortify the portfolio.
The real world
You can profit in an unstable market, Mr. Richards reminds his readers. “Moreover, these five principles aren’t mere theory. They actually work in the real world!”
He notes that if he is incorrect and the markets start rampaging upwards again, “the worst that can happen with my approach is you’ll underperform the markets.
“But if I’m right, you’ll be in a much better position to weather the storm. You’ll also be able to take advantage of any potential sell-offs.”
Step one in the plan, not surprisingly, begins with a thoughtful selection of fixed-income investments.
Reward is king
When markets are strong, observes Mr. Richards, “it’s always interesting to hear the experts advise folks to reduce their fixed income, but increase their exposure to equities.” Pursue double-digit stock returns, they say. Ignore single-digit fixed-income returns.
“Risk becomes a forgotten factor. Reward is king.”
Yet as investors grow older, they should hold a steadily increasing percentage of fixed income, the analyst insists.
We also face the spectre of rising interest rates. It’s time to have money in short-term paper.
“I’m also buying inflation-protected bonds, known as Real Return bonds,” says Mr. Richards. His investment is iShares Canadian Dex Real Return Bond Index Fund (TSX-XRB). It is trading at $23.10.
Don’t give up on fixed income just because you don’t like interest rates, adds the analyst. You may end up liking a 3 per cent GIC or bond return a whole lot better than a 25 per cent stock market loss.
Top-down, bottom-up
Step two entails “top-down” analysis of the market. That is, looking at the wider market and the sectors that should do well in the months ahead.
Consumer staples — the things we all need no matter what — get top billing. Mr. Richards has two ETFs for this group of stocks.
The first is American. Consumer Staples Select Sector SPDR (NYSE-XLP) trades at $32.11. Unfortunately it’s not hedged to our dollar, so there is currency risk. But it tends to do very well in the summer months.
And now there’s a Canadian equivalent. iShares S&P/TSX Capped Consumer Staples Index Fund (TSX-XST) is a newcomer, launched in April. It trades at $20.52. It includes such “stalwarts” as Shoppers Drug Mart (TSX-SC), currently trading at $41.10 and yielding 2.4 per cent on its $1 dividend, and Loblaw Cos. Ltd. (TSX-L) which has rallied recently and trades at $41.01 with a 2 per cent yield on its $0.84 dividend.
At the same time, Mr. Richards is rotating out of the energy sector, and out of the broader market as well, selling several index ETFs.
Step three is the opposite tack. It’s the “bottom-up” analysis used to uncover individual stocks that will outperform the market in difficult times.
Earnings stability is the key, and this team identifies two it particularly likes. One is U.S. tech giant Oracle (NASDQ-ORCL). Its earnings are stable and it should be the best long-term performer in its sector, says the analyst. It trades at $33.71 and yields 0.7 per cent on the $0.24 dividend.
The other is a venerable Canadian company this team has held for a long time — Canadian National Railway (TSX-CNR). Its steady growth and superior management make it a core holding for many portfolios, says this analyst. It’s at $73.30, yielding 1.8 per cent on its $1.30 dividend.
Win by not losing
Step four is risk management. Essentially, this means cash. Using the top-down approach, Mr. Richards likes to hold cash when the market starts sending out aggressive signals.
For brief periods, he and his team will also hold inverse ETFs that benefit when the market goes down. They do not use the leveraged ETFs that promise 2-for-1 returns. The idea is not bet on the downside, but to use cash and inverse ETFs as safety and risk-hedging strategies.
“In other words, we try to win by not losing.”
The two recommended ETFs cover Toronto and New York. Horizons BetaPro S&P/TSX 60 Inverse (TSX-HIX) trades at $10.44. Horizons BetaPro S&P 500 Inverse (TSX-HIU) trades at $7.81.
Step five asks you to swim against the tide. Take a contrarian viewpoint from time to time, Mr. Richards advises his readers in Investor's Digest of Canada.
Buy when others are too pessimistic and sell when they are too optimistic. Look at investor sentiment as the markets rise and fall and you can find “the potential risks or opportunities that herd behavior creates.”
Today, markets appear to be recovering their balance. But wise investors will stick to a plan, says this analyst. Protect yourself from the worst that can happen, and the profits will take care of themselves.
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