Portfolio Protection Is Paramount

 | Aug 02, 2011 | 1:30 PM EDT
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It's time to set aside valuation considerations and start thinking about portfolio protection. Echoing comments made PIMCO's CEO Mohammed El-Erian, the events that have transpired around the debt-ceiling debate will likely have "long-lasting consequences." Though it appears likely that the Senate will approve the debt measure passed by the House, the political back and forth over the past months have given rating agencies considerable reason to question the AAA credit rating on U.S. debt.

The debt ceiling measure outlines a path to spending cuts going forward. While the U.S. clearly has to do something about its budget deficit, the market will likely see things through one prism: Future spending cuts will restrict growth and will hurt an already limping economy. The headline effect on consumers seems to have already materialized: U.S. consumer spending fell in June for the first time in two years as a hiring slump sent consumers back into fear mode.

For investors, protecting one's portfolio is paramount. A few months ago, I discussed the virtues of holding cash. Cash offers protection and provides flexibility to act when times become volatile. But, since very few investors want to read an entire column on the virtues of cash, it's back to basics in terms of insuring your portfolio.

The most obvious trade is to buy put options on the S&P 500 via the SPDR S&P 500 (SPY). As simple and basic as this approach may be, don't discount its effectiveness in today's environment. If the market corrects by 10% from here during the next several weeks, the September 2011 $120 puts, currently selling for $1.50, would be worth about $5. Today, SPY trades at $128, and a 10% correction would put it at about $115; thus, giving the $120 put a $5 intrinsic value.

An investor who believes greater volatility is in store for the market can make a more levered bet on a market decline via the ProShares UltraShort S&P 500 (SDS). SDS is a levered ETF that can pay off effectively amid volatility and a downward market.

With regard to stocks, use large-cap, dividend names as "placeholders" for cash while the next few months play out. Small-caps have outperformed larger, high-quality names by a wide margin and this will likely result in a greater selloff during a market correction.

McDonald's's (MCD) affordable menu will likely continue to do well in the current economy, and the company earns more than half of its income from outside the U.S.; the shares yield nearly 3%. Pharmaceutical giant AstraZeneca (AZN) trades at under 9x trailing earnings and yields 5.7%. Consumer products giant Clorox (CLX) yields 3.4% and trades at $71, 15% below the $80 buyout offer from activist investor Carl Icahn.

Investment success always relies on loss avoidance. U.S. markets could be entering a period of turbulence due to a toxic combination of a credit rating downgrade and a slowing economy. Forget about hitting home runs and focus on avoiding strike outs.

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