Portfolio Insurance For Bullish Investors (FAZ, SEF, UYG, SKF, TBT, TBF, TMV, SBND)

Steve Reitmeister:  Weekends provide a valuable time for investors to pause and reflect. That’s because during the week there is such information overload that it’s often hard to bring the full investment landscape into focus.

So this weekend I did some hard reflection regarding the “big picture” right now. The problem is that I see two potential outcomes. One is great for investors. One is horrifying. And because of that I have adopted a portfolio that prepares for these two diverse outcomes.

Let’s start by discussing the two disparate investment outlooks.

Big Picture #1: Moderately improving economy = moderately improving corporate earnings = moderately improving stock market. I shared the core fundamentals reasons for this pro-stock stance in an article I posted on Seeking Alpha earlier in the month entitled 4 Reasons Why Stocks Are Ready to Make New Highs.

Big Picture #2: Potential disaster from (take your pick of)

  • Fresh eurozone credit problems. Ireland now. Who’s next? And does it wash to our shores?
  • Mortgage/banking issues perhaps not truly fixed.
  • Enormous US debt burden (federal and state) that others may not want to finance much longer. (aka sovereign debt crisis)
  • Quantitative Easing Part 2 (QE2) policies that have many critics and many potentially harmful unintended consequences like dollar devaluation, currency war, rampant inflation etc.
  • And if any of these really took root, then yes, double dip recession and all the pain that comes with it.

I still think that the strong preponderance of the evidence points to the modestly bullish case (Big Picture #1) being the most plausible. Yet that doesn’t mean we should cast a blind eye to case #2. I talked about this same scenario back in late August when the market was pressing down on Dow 10,000 (see Russian Roulette, Stock Market Style).

I wrote that article to make the case for not giving into the rising fear. Instead folks should stay invested in stocks given the positive fundamental outlook. That was the right call then. But now the market is 12% higher. Is it now perhaps prudent to pull in the reigns a bit just in case any of the pitfalls of Big Picture #2 take root?

Portfolio Insurance Is the Answer

To be clear, I am not running for the hills as I still suspect the muddle through case for the economy and stocks is the most likely. However, if something blows up overnight, as it has in the past, then buying protection afterwards may be too late. So best to take on some positions that act like portfolio insurance. And yes, insurance always seems like a waste of money until you need it. Maybe we need it given the growing list of concerns I shared above.

The two most likely kinds of disasters that could take place overnight leading to heavy losses as the market opens the next day would be the following:

Sovereign Debt Crisis

We clearly have a ton of debt on the books (and off the books too). At some point there may be no more appetite for government debt at such low rates leading to a tremendous spike in rates. The best form of insurance here would come from ETFs that profit as rates rise. Or simply, they short US bonds. My personal favorite choice is the ProShares UltraShort 20+ Year Treasury (NYSE:TBT) which is a 2X short of the 20+ year Treasuries.

If you have a good appetite for risk then you can ratchet up to 3X shorts like the Direxion Daily 30 Yr Trsy Bear 3X Shares (NYSE:TMV) and the PowerShares DB 3x Short 25+ Year Treasury Bond ETN (NYSE:SBND). On the other hand, if you don’t care for all that leverage then just go with the ProShares Short 20+ Year Treasury (NYSE:TBF) which is the 1X version of what (NYSE:TBT) is doing.

Banking Crisis

Since 2008 I have stayed away from bank stocks with a 100 foot pole (ten foot pole was just not good enough). Why’s that? To me the banks and the Government are acting like my 8 and 10 year old daughters.

How’s that? When I ask them to clean up their rooms, they scurry around as fast as possible and throw all their stuff in the closets. On the surface the room is clean. Then when you open up the closets you get buried under all the garbage they threw in there.

To me that is how the government and the banks cleaned up the mortgage mess. I don’t think the bad debt is really cleaned up. I just think it’s hidden in the closet and under the beds (so to speak).

And the more I read about it, the more uncomfortable I become. The recent mortgage foreclosure problems being the most recent hiccup. And I am concerned there are more to come.

So if there is another weekend in our future where we discover another Bear Stearns/Lehman type scenario, then shorting bank stocks on Monday morning will be too late. Better consider that now as further portfolio insurance.

I don’t think it wise to try and pick and choose which of the big banks will falter. If something new hits, it will most likely mean they are all in trouble. So best that you go with an ETF that rounds up all the usual suspects Bank of America (NYSE:BAC), Citigroup (NYSE:C), JP Morgan (NYSE:JPM), Wells Fargo (NYSE:WFC) etc..

On the ETF front you have a number of good ETF choices like the Direxion Daily Financial Bear 3X Shares (NYSE:FAZ), ProShares Short Financials (NYSE:SEF), ProShares UltraShort Financials (NYSE:SKF), and the ProShares Ultra Financials (NYSE:UYG). Just make sure the holdings of the fund focuses more on the big money center banks and doesn’t really include much in the way of insurance companies or credit card firms.

Putting Everything in Focus

I know that discussing a potential banking or sovereign debt crisis makes it sound like it’s “game over” for the stock market. Yet that is not the point of this article.

The simplest way for me to say it is that I still think the preponderance of the evidence points towards a muddle through economy with modestly improving corporate earnings and modestly higher stock prices. That is why I am currently 75% long the stock market.

However, given my rising concerns about the banks and government debt, then I have taken the rest of the funds to buy myself some portfolio insurance against these potential calamities. My true hope and desire is that my stocks keep rising and I end up selling these defensive positions down the road for a loss. Yet I will certainly sleep better at night knowing that I do have these insurance policies in place in case trouble does start to brew. I hope you consider the same if you haven’t already.

Written By Steve Reitmeister From Zacks.com

About Steve Reitmeister: I am the Executive VP of Zacks Investment Research in charge of Zacks.com and all its services for individual investors. I have a top down investment approach with a focus on value and upward earnings estimate revisions. And there is nothing I enjoy more than sharing insights with fellow investors.

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