March 3, 2008 in Investing

8 tips for investing in hard times

The economy occasionally heads south. When it does, you have to take a close look at your finances and review, regroup and perhaps recoup.

Real estate in many markets has lost its luster. Bonds are either mired in controversy or priced at levels where it’s hard to imagine much of an upside. The yield on cash investments has trended lower with the Federal Reserve’s easing of its targeted federal funds rate from 5.25 percent in August to 3 percent in January 2008. As for stocks, well, stocks have been bouncing between the promise of a new tomorrow and the fear of facing tomorrow. What’s an investor to do?

Definitions
  • Federal funds rate — The short-term interest rate that banks charge other banks to borrow money overnight at the Federal Reserve.

See the Guide’s Glossary for a further explanation of these terms.

Despite several rate cuts and the federal stimulus checks that went out beginning in April, it appears that the U.S. economy is running scared of a recession.

Since we won’t know we’re in recession until the economists at the National Bureau of Economic Research, or NBER, tell us we’re in a recession, it makes sense to think through how we’re invested and changes we can make to improve our portfolios or finances now.

To that end, Bankrate has asked a group of investment professionals and investment journalists to weigh in on how an investor should prepare for or invest in hard times.

1. Pay down loan balances and earn a guaranteed return

Not all financial moves you make when you expect hard times relate to your portfolio. Taking some steps to manage your spending can help you position yourself to survive a financial setback such as getting laid off from your job.

William Suplee IV, CFA, CFP, president of Structured Asset Management in Paoli, Pa., suggests that, “In difficult economic times, often simple things can make large improvements to your personal financial situation.

“One simple way to earn a good return is to start paying down existing credit card balances. The return you will earn will be equivalent to the rate charged on the existing card balances. In many cases, this return will be hard to top in a difficult investment environment. A smaller balance will allow you to have more credit available for temporary needs in times of emergencies.

“It might also be a good time to request an increase in your credit limit to give you even more room for future contingencies. If you have trouble making additional payments, setting yourself up with an electronic automatic payment plan with your bank will keep this going on automatic pilot, just like your 401(k).”

2. Be prepared

Just like the Boy Scouts suggest, it can make sense to be ready for the worst while hoping for the best in the economy and your personal finances. Jonathan Clements, senior special writer for The Wall Street Journal, offers the following tip:

“Set up a home equity line of credit. Recession means lay-offs, and a lay-off means you will need cash. Sure, it’s best to have a pile of money sitting in a high-yield online savings account or a low-cost money market fund. But failing that, a line of credit could come in handy.

“Sound attractive? Set up the home equity line of credit now, while you’re still employed and still appear creditworthy.”

It’s a paradox. Banks don’t like to lend money to people who need it. Borrow before you need it and both you and the bank are happier.

3. Look beyond tomorrow’s headlines

The stock market is a leading economic indicator. A decline in the stock market may help predict hard times, but it should also be the first indicator that the economy is turning around.

“This is the time to be buying stocks.”

The Wall Street Journal’s Clements suggests that you “Ignore the headlines and anticipate the recovery. The worst for the economy may be ahead of us. The worst for the stock market is probably behind us.

“This is the time to be buying stocks, not selling them. Stock investors have already discounted a slowing economy — and, with the recent rally, investors seem to be looking ahead to better economic times.”

4. Stay the course

David Landis, CFA, a contributing editor at Kiplinger’s Personal Finance, advises investors to stay the course.

“Presuming your readers have diversified portfolios, they were designed for times like these. Portions of the portfolio that are expected to outperform during a slowing economy will presumably do so. And when the recession has run its course, which may be sooner than we think, the parts of the portfolio that traditionally outperform in a recovery are already in place and ready to pop.

“Yes, you could try to shift your portfolio into a defensive stance, but chances are you would miss the turning point and what could be a substantial run-up in stocks in anticipation of a recovery.”

5. Find your ‘sleep number’

Investors often find themselves running with the crowd when markets trend higher, increasing their investment allocations to stocks, bonds or real estate. Sometimes this happens just through the growth in an investment’s value, increasing its weight in the portfolio. Other times it happens because the investor sees the high returns in one market and wants to increase his exposure to that market.

David Stevens, CFA, CIMC, a senior investment strategist at Wells Fargo Family Wealth Group in Minneapolis, suggests that now is a good time to re-evaluate the amount of risk you are comfortable with in your portfolio and adjust it accordingly. He thinks investors should find the level of risk in their portfolio where they can get a good night’s sleep whether it’s an up market or a down market. Call it your sleep number.

If there is too much risk in the existing portfolio, Stevens cautions that the investor should avoid getting too defensive in how they invest, running to cash investments only to jump back into other investments later and too late.

Signs of a slowing economy:
  • Less traffic at your local airport means less business and personal travel. Check your local newspaper for airport traffic statistics.
  • More “For lease” signs in storefronts and office buildings when it isn’t right after the holidays could mean businesses are consolidating space or laying off employees.
  • Desperate discounting by airlines, car dealers and stores. “You get 15 percent off coupons for one store item all the time,” says Cassidy. “But 25 percent or 50 percent off any item in the store sounds like desperation.”
  • Politicians and economists start saying “slowing growth” or “soft landing,” because they never want to say the word “recession” too early.
  • Consumer consumption stalls or begins to drop. See whether same store sales growth for companies like McDonald’s is flat or decreasing.
  • Stock prices of major retailers like Target or Kohl’s decrease when the rest of the stock market is reasonably OK.

He wants his clients to hold well-diversified portfolios that include: stocks, bonds, cash, real estate and commodity investments. The whole portfolio needs to be internationalized, Stevens suggests, not just the stock portion of the client’s investments.

Stevens suggests that a client who is convinced that hard times are ahead should consider long/short mutual funds where the investment manager of the mutual fund is looking to capture returns from underperforming sectors and markets, too.

6. Start looking for value plays

Tomas J. O’Loughlin, CFA, of Investment Portfolio Management, suggests that the best investment decisions in hard economic times are counterintuitive.

“Sectors or companies that you liked in good times but have been hit in today’s markets may represent buying opportunities.”

Buying the best of breed in these sectors can position investors to take advantage of the next bull market.

His checklist in evaluating these firms includes:
  • Are they going to go out of business in the next three to five years?
  • Does the company have a strong management team?
  • Does the company have both strong financials and access to capital?
  • Is the company expected to continue to lead in its field?

An investor can’t be in a hurry to buy or sell, says O’Laughlin.

“Don’t try to catch falling knives,” says O’Laughlin, and “try to get a measure of the firm’s downside risk.”

By looking at the downside risk of firms and by taking an investor’s perspective, looking over a three- to five-year investment horizon, versus a trader’s point of view, the investor can identify firms with value, O’Laughlin says.

7. Keep money in stocks

It’s important to keep a portfolio allocation in equities, even when you’re nervous about them, say William Trent, CFA, a freelance equity analyst who is also the editor of an investing Web site, Stock Market Beat, and a writer for TheStreet.com.

Trent suggests that an investing strategy that will work in down markets is to write put options on stocks to capture the premium income on stocks you would be willing to own if the put was exercised.

He offers an example of selling a put option on a stock with a strike price of $20, a current market price of $20, a July option expiration and an option premium of $2.

If the price of the stock goes up or remains at $20 per share, then the put isn’t exercised and the option writer keeps the put premium of $2 per share, $200 per contract. (Option contracts on stocks are written on 100 shares of stock.)

Definitions
  • Put option — A put option gives the owner of that option the right, but not the obligation, to sell 100 shares of the stock at a set price, called the strike price, on or before the expiration date.
  • Strike price — The specified price on an option contract at which the contract may be exercised.

See the Guide’s Glossary for a further explanation of these terms.

If the stock price falls below $20 per share, the put is exercised and the put option writer has to buy the stock at $20 per share, $2,000 per contract. The premium income offsets part of the cost so the put writer effectively owns the shares at $18 per share, $1,800 per contract. This example ignores commissions and taxes.

This approach is not appropriate for neophyte options traders but can work well for investors who are willing to accept the risk that they will wind up owning the stock at the net cost if the contract is exercised against them.

8. Don’t chase yield

Lynn Mander, CFA, CFP, chief investment officer of First National Bank of Chester County in West Chester, Pa., says that the current investment environment is not a good time to chase yield in the bond market.

She points out that bonds historically have been seen as a haven in economic downturns as investors flee the stock market and look for the interest income paid by bond investments. But what’s different this time is that the stock market and the economy are feeling repercussions from problems in the bond market.

Unsophisticated investors don’t have the tools to properly evaluate the bond investments, says Mander. Quality is the name of the game in bond investing, whether it’s the full faith and credit pledge of an FDIC-insured CD investment or the credit quality of U.S. Treasury or government agency debt, says Mander, while the municipal market is seeing risk positions shift with the changing status of municipal bond insurers.

Mander also advised that investors should be cautious in considering annuity contracts in what is essentially a low interest rate environment for fixed income annuities.