- We’ll discuss what a good defensive stock would be for the next market crash.
- We’ll discuss Treasury inflation protected securities (TIPS).
- We’ll discuss how gold miners can protect your portfolio.
Yesterday, I discussed how a stock market crash can happen anytime. However, most of the triggers that I mentioned would have had the same credibility in 2012. Therefore, getting out of the market now might not be the smartest idea.
It’s important to remember that time in the market and dividends are the main contributors to long term wealth creation.
As there is a possibility that the S&P 500 crashes in the next 12 months, there is also the possibility that it continues to rise for the next 5 years, or that it at least doesn’t crash significantly in the next five years. Therefore, the best thing to do is to be prepared for a crash so that no matter what happens, you do well and you sleep well.
No one knows what will happen in the stock market, not even Warren Buffett. What Warren Buffett knows is that if you buy quality at a good price, you are bound to do well. Let’s dig into some ways to protect your portfolio that won’t make you miss out on anything but will definitely help you sleep well.
Now, you might think that there are some stocks that won’t be affected in the next market crash. For example, stocks like the pharmaceutical giants Pfizer (NYSE: PFE) or Johnson & Johnson (NYSE: JNJ).
From September 2008, JNJ and PFE dropped a bit less than the S&P 500 but nevertheless still dropped more than 30% while the S&P 500 dropped more than 40%. The interesting thing is that up to November 2010, the S&P 500 had recovered and beaten both stocks. Therefore, going into defensive stocks might make you sleep a bit better, but you shouldn’t consider yourself protected.
Index ownership has substantially increased in the last 8 years and consequently, all those blue-chip stocks that might look like defensive plays will suffer the same fate as the market due to panic selling from investors that own index funds.
As there is a large probability that central banks and the IMF will immediately intervene with any signs of financial trouble by adding more liquidity into the system where more liquidity means higher inflation, especially if central banks lose a bit their tight control, perhaps the best defensive stocks will be the ones with real assets backing their businesses and stock price.
I’ve already discussed how book value is extremely important when investing, but it’s also important to go beyond the actual book value of a company. In a stock market crash, companies with lots of intangible assets, especially goodwill, might not have any real assets to offer protection from the downside and inflation. So just as a matter of protection, if you can choose between two similar companies with equal prospects at this moment in time, I would choose the one with a high level of tangible assets on the balance sheet in relation to the stock price.
Further, higher inflation in an economic downturn would really put a lot of pressure on highly indebted stocks, especially those who have junk credit ratings like Tesla (NASDAQ: TSLA), or a country like Italy which is just a notch above junk status.
Let’s look at the price to book value of the S&P 500 to see if there is protection.
What’s very important is to always question the book value number. For example, Exxon (NYSE: XOM) has had minimal impairments of its assets, even though oil prices dropped, where one could really question if all the assets on XOM’s balance sheet could be sold at book value prices. Similarly, JPMorgan might hold various financial assets that can become worthless in a financial crash. Nevertheless, from a book value perspective, the top of the S&P 500, which makes up 20% of the index, doesn’t really offer much book value protection. Therefore, look elsewhere for stocks backed by real assets, that can have stable revenues during a recession, and possibly transfer higher prices due to inflation to customers.
Sound impossible? Well, don’t forget the saying: you usually find what you’re looking for.
Here is a tip on such a stock: The Andersons (NYSE: ANDE). ANDE is trading close to book value and is cheap due to negative pressures on its complete set of businesses: grain, ethanol, rail, and plant nutrients.
Cash As Protection
Cash might be a good asset as it allows you to buy on the cheap, but in the case of inflationary pressure or currency depreciation, you have to be very careful with holding cash in a long-term situation. The best place for cash might be Treasury Inflation Protected Securities (TIPS) which are liquid and can give you the liquidity when needed if you live in the U.S. or want dollar exposure.
How many TIPS you should own depends on your risk reward situation. If you can’t risk volatility because you need to retire tomorrow, I would own a bunch. If you are 20 with a small portfolio, I would wouldn’t own any at all.
A gold hedge is essential protection, especially in the current monetary easing era. Every portfolio should have some exposure to gold.
In the case of economic collapse or a stock market crash, what might be even better than owning gold might be to own gold miners. Personally, I prefer gold miners because of their higher leverage to gold prices.
Let’s say gold prices double while the S&P 500 crashes 50%. If you own physical gold, you would have to have 33% of your portfolio in gold now to mitigate the 50% stock market crash.
If you own a gold miner and gold prices double, the stock of such a miner would probably increase 5 or 10-fold because the miner’s revenue would double while its costs would remain relatively fixed.
So Barrick Gold’s (NYSE: ABX) earning per share would increase more than 3 times if gold prices rise. Additionally, the company’s resources and reserves would become much more valuable and increase the value of the stock. In such an environment, I wouldn’t be surprised to see ABX’s stock price increase 5-fold or more. This means that in order to mitigate a stock market crash of 50%, 10% of a portfolio in gold mining stocks would be enough. Various mining stocks would react differently and each miner carries individual risks, so be sure to assess the situation in relation to your own portfolio.
If gold prices fall 50% and your portfolio is 33% exposed to physical gold, you lose almost 17% of your portfolio. If gold falls 50% and you have 10% of your portfolio in gold miners, if those stocks fall 90%, you only lose 9% of your portfolio for the same protection.
It all boils down to your personal situation. If you are 60, waiting to retire and have a 60/40 stocks to bonds allocation, I would really rethink your complete portfolio. If you are 20 and you are long Amazon, Apple, and Nvidia, even if the market crashes, it won’t make a big dent in your financial life as long as you are ready to invest part of your income during the crash.
Therefore, see how the above portfolio protection tips fit your personal financial goals. It’s all about how investing risks and rewards fit your personal finances.