The countdown to the New Year has begun but before the ball drops, actually before 4 PM EST on that Monday, review your investments and place your sell orders for tax-driven transactions.  For stocks and other securities, make sure your order is placed in time for it to be executed. This is particularly important for thinly traded stock and bonds. Taking a loss will offset gains and you can take an additional $3,000 of losses (on a joint return; $1,500 on a single return) in excess of capital gains as a deduction on your income tax returns. For the maximum advantage, try to offset short-term gains with short-term losses and long-term gains with long-term losses. 

 

For mutual fund investors, even if you haven’t sold any funds this year, you still many have a taxable capital gain. Mutual funds must pass through their net capital gains or losses, and income, to their holders. Give your fund a call if you haven’t heard from it about its 2007 distributions. And, as a general rule, sell a fund before its announced distribution date and buy a fund after that date. This avoids your having to pay taxes on its distributions.

 

If you’re selling your entire position in a fund or security skip to the next paragraph, but if you’re selling a portion of your holding you need to specify the tax lot(s) you’re selling or the First In, First Out (FIFO) rule will apply.  The potential trap here is if you hold a fund or security which you bought at various times, the cost basis of each transaction could be very different. Make sure you specify the most advantageous tax lot to sell.   Mutual fund investors have a third option which is to use the average cost of their holding. Note: Before you make any tax-based decisions you should consult your tax adviser.

 

It’s not too late to make, or maximize, your 2007 IRA and 401-K contributions. Why make them? Because these are tax-deferred accounts. Even if your income is such that you can’t take a deduction for your IRA contribution, once contributed all income and gains are tax deferred.  Then, the power of tax-free compounding works for you. Using these accounts, investors can convert taxable interest and dividend (especially non-qualified) income into tax free (until they begin withdraws at age 70 ½) income. For investors seeking to diversify their portfolios in a tax efficient manner, retirement accounts are a great place for high yielding taxable investments.

 

So before you settle in to watch football or hide from the in-laws review your investments and minimize your tax liability. When the flowers come up in April, you’ll be glad you did.

If you get caught holding in football your team loses yards. If you get caught holding in your portfolio you lose money. There is no such thing as a hold investment. Yes, I know, every day hold recommendations are issued by Wall Street analysts but they’re copouts. Every investment recommendation that is not a buy is a sell, regardless of what label’s put on it. There are only two investment decisions: buy and sell. If you own a stock, bond, mutual fund, ETF, house, or car and don’t sell it, you’re making a buy decision. Why? Because you’re continuing to hold the asset and subjecting yourself to all the risk that comes along with it.

 

The buy/sell decision doesn’t mean you have to keep buying more of an asset but it does mean if you think an asset is fully priced, you should sell it.  It’s okay to hold an investment you’d otherwise buy if you’ve reached your maximum hold size given risk tolerance levels or portfolio diversification considerations. Saying an asset is a good investment but its fully priced is really saying that it’s peaked in value and it’s time to sell.

 

There are two exceptions to the buy/sell rule for taxable investors. If you have a short term gain which will turn into a long term gain if your hold for a few more days – and the operative word is days – then it would be worth considering holding the investment. Holding may also be worth it if you’re approaching the end of one tax year and by holding for a few days you can push the gain into the following year. This one’s particularly relevant right now, since most of us are on a calendar tax year. There’s a knee jerk reaction to make investment decisions based on minimizing taxes. Minimizing taxes is good but what’s even better is maximizing your net worth.  Calculate how much you’ll save in taxes if you’re holding for tax reasons, then calculate hold much – in most cases how little – the investment has to fall in value before you’ll have less money than if you sold it now and paid your taxes. I have no statistical proof, but I believe that most investors end up losing money by holding an investment in an attempt to avoid or minimize taxes.

 

Investors are emotional beings and we become attached to our investments. We don’t like to admit we’re wrong and sell a loser. It’s all too easy to hold an investment where we have a gain, in hopes of even greater profit, for too long. We need to accept that we don’t always pick “winners” and we’re not smart (lucky) enough to sell at the top. Investors also have a tendency to be on the lookout for new investments and become compliance about those they already own, particularly if they have a gain in them. We should place the greatest focus on our existing investments. The questions we need to ask ourselves are: is the investment consistent with my investment objectives and have my objectives changed? How will this investment perform given the current economic outlook? Has anything changed with the investment, the fund manager or the company’s prospects? Lastly, ask yourself if you didn’t own a particular investment, would you buy it today? If the answer is no, you know what you must do.

Or a Yuan. (My apologies to all you Cabaret fans.) As a mutual fund or ETF investor you need to be aware of the currency risks you’re taking when investing internationally. Is your fund hedged against the dollar or not? Do you want your fund to be hedged or not? What difference does it make to you? Let’s start with the last question first.

 

Currencies do fluctuate is value, except for the Yuan.  Its exchange rate is fixed by the Chinese government, but even the Chinese are responding to pressure to let the Yuan float upward in value against the dollar.  The dollar has declined against the major world currencies for the past seven years. Take the Euro, for example. The current exchange rate is about €1.00 = $1.46, a slight decline for the recent record of $1.49, but a big change from the one-to-one exchange ratio in 1999. Any dollar based investor, such as those of us in the good ol’ USA, would have seen substantial appreciation in his or her Euro dominated investments – European stocks and bonds – made a few years ago just based on currency movement (assuming the currency wasn’t hedged). The European investor who bought dollar dominated US stocks or bonds wouldn’t have been so lucky. The Dow at 13,000 would have brought little joy to the Euro investor’s heart since most of his or her gains would have been offset by the deprecation of the dollar versus the Euro. 

 

There are ways to protect yourself against currency swings.  You can make you international investments through a mutual fund which hedges – tries to eliminate or minimize the currency risk. No hedge is prefect and all hedges cost money which reduces your return, but a currency hedge factors out one risk, leaving you with the underlying risk of the investment, i.e., the performance of the stocks or bonds in the mutual fund portfolio. Mutual funds disclose whether their strategy is to fully, partially or not hedge, so read up on your international fund before you invest in it. If you invest in a fund which doesn’t hedge you can mitigate the currency risk by investing in an ETF which is designed to go up in value as the dollar appreciates.

 

Hedged or unhedged, which is right for you? It depends, first and foremost, on how much risk you want to take. Unhedged, an adverse currency swing could wipe out all the fund’s portfolio gains and, particularly in a bond fund actually result in a loss. Secondly, it depends on your outlook for currency movements. 

 

Global diversification is an essential part of your investment strategy.  Like every other investment, you need to do your homework and understand how much, and what, risk you’re taking.

When the major stock market averages declined by 10% from their 2007 highs on Monday, we were in official market correction. Sentiment is negative owing to the economic back drop of, at best, tepid growth according to the Fed, or a recession.

 

Consumers twenty-five year credit binge fueled by home equity loans, credit cards arriving in the mail, subprime and adjustable rate mortgages and automobile leases, appears to be over. Savings rates has plummeted from 14% to 0% (perhaps to a negative number if home values continue to decline). Pile on top of that the banks debt problems, high energy prices, the homebuilding industry’s woes, weak retail sales and declining consumer sentiment, it’s no wonder that many investors believe a recession is in the offing.

Investors face two challenges right now. If the economy is headed into a recession, where do I put my money? And, if the economy avoids a recession will I be in the right investments? The stock market anticipates the future. It will decline prior to the US entering a recession and it will start going up prior to the end of the recession. Investors who wait for certainty that a recession has begun will be selling stocks at the worst possible time. The same logic holds true if you wait to buy stocks until after the economic recovery, the market will have already moved higher in anticipation. Human psychology is a future complication. We’re most optimistic about the stock market when it’s roaring ahead and most inclined to buy; and most pessimistic and most inclined to sell, when it’s at its bottom. Of course, our investment strategy should be just the opposite.  The moral to this story is that you should invest for the long term and not try to time the market. 

 

If a recession is imminent, the stock market will decline by another 10%. How do you make money? To get technical, buy mutual funds, ETFs and stocks with negative betas or high alphas, such as gold, commodities, real estate and foreign stocks. Gold and commodities already have had good runs, the US commercial real estate market appears to be weakening and foreign economies are increasingly becoming intertwined with ours. Non-investment grade bonds have good yields but are not the place to be given the continuing bank credit problems. High grade bonds and Treasures have relatively unattractive yields, particularly as you go out in maturity.

 

The best performing stocks in a recession are likely to be industry leaders, companies with strong overseas sales, consumer staples and health care. The technology sector is solid and internationally focused, so we’ll add it to our list. Essentially we’re looking at companies whose sales will be strong during a recession. These stocks may not go up in price during a recession but they will perform relatively better than most other equities and are safe investments. The bottom line is it’s hard to make money during a recession.

 

If the Fed is right and we’ll see modest economic growth in 2008, the markets are at their lows and could move 20% higher over the next six months. How do you position your investments for this possibility? By staying in the market and buying the same mutual funds, ETFs and stocks as you did for your recession portfolio. The recession portfolio is a conservative portfolio. Although it will miss some of the dramatic gains made by small cap and more violate stocks, it also protects you from the downside of those stocks while enabling you to participate in any stock market rally.

 

What to do now? Review your long term goals and make sure you’ve got the right asset mix, take losses (up to $3,000 more than your gains, remembering to match short term gains and losses) to minimize your taxes, reposition your equity investments according to our recession scenario, move your bonds into cash and tighten your seatbelt. We’re in for a bumpy ride.

The world’s second biggest economy is Japan (behind the good ol’ USA). China, India, and Brazil have economies growing at upwards of 10% annually. That’s a lot faster then the roughly 2.5% expected US growth over the next year or so (absent a recession, of course). Together those three economies almost equal the U.S. in GDP.  Add in Japan, and the combined GDP of these four countries exceeds the U.S. The CIA’s World Factbook is an excellent source of country information like this.

 

A good mutual fund investor would be wise to have at least 25% of his or her assets invested outside the US. Global investing makes sense not only to avail oneself of higher growth rates but also because international investments may respond differently to the same event. Global economies is linked and becoming more so. The stock markets of Western Europe, for example, have an 80% correlation with the U.S. markets.  Makes sense, doesn’t it? A good portion of BMW’s profits come from the U.S., so if the U.S. economy (and the U.S. stock market) turns down, so does BMWs profits and its stock price on the German exchange. You don’t gain a lot of diversification by investing in Western Europe (although it would be a play on the Euro, if you think the dollar will continue to decline). Something of a surprise is that the Brazilian stock market has a 70% correlation to its U.S. counterpart. Latin America is more closely liked to the U.S. then it would like to believe. As you’d expect, the stock markets of emerging counties, i.e., China (50%), India (40%), Russia (35%), are not as closely correlated with the U.S. market as are the Western European markets. (Of course, they’re also more volatile.)

 

A second surprise is the uniqueness of the Japanese market. Movements in Japanese stock prices have only a 30% correlation with movements in the U.S. stock market. That’s surprising because Toyota sells so many cars here and we all own at least one Japanese made TV. But it goes to show that the biggest driver of any economy is what’s going on inside a country, not how much it exports. Just like the Japanese culture, there are many unique aspects to the Japanese economy. What’s also nice about Japan is it’s the second largest economy in the world and offers the legal and accounting safeguards of a mature county. Thus, you can diversify without emerging economy risk.

 

How to decide which regions/countries to invest in? Which counties do you think are attractive investments, i.e., their economies will grow. What are the opportunities in Mexico (domestic demand)? Canada (natural resources)? Germany (banking and automobiles)? Then, like with every other investment decision, consider the riskiness of the investment. Canada and Germany are pretty safe. Russia’s GDP is clipping along at 7% per year and Egypt’s GDP is growing at 6%. Both stock markets reflect this growth but they’re riskier investments.

 

There are many excellent international mutual funds and ETFs, some invest globally, some focus by region and some by country.  International funds invest in all sizes and types of companies and, for the fixed income portion of your portfolio, all classes of debt.

It would be wise to invest 25% of your assets internationally and to diversify beyond Western Europe.

Exchange traded funds are index funds which have advantages over open-end index mutual funds. ETFs trade all day long on the stock exchanges, may be purchased through any broker, have lower fund expenses than mutual funds, and have less likelihood of generating unwanted taxable gains than mutual funds. (See The ABCs of ETFs – Exchange Traded Funds).  

There are a number of reasons, which we’ll discuss, for investing in index funds (ETFs or mutual funds) but let’s start with the fact that the S&P 500 index beats 80% of all actively managed funds. (And, an index fund has lower expenses than an actively managed fund, further enhancing its net return.) If you can invest in an index fund and be in the top 20 percentile of fund returns, that’s a pretty good place to start. 

 

You can construct a well-diversified portfolio entirely out of ETFs.  There are ETFs for almost every type of investment you can imagine.   ETFs enable you to diversify into assets which you may not otherwise feel comfortable owing because of expertise, risk and/or liquidity issues. ETFs are well-suited for investing in exotic areas such as currencies and commodities. Of course, they’re great for sectors such as small cap or international stocks. 

One of the most attractive features of ETFs is their ability to provide you with greater liquidity than if you were to directly own their underlying investments. Take municipal bonds, for example. Most Muni issues trade infrequently and the transaction costs for the individual investor are substantial. Minimum investment size can be another problem. Munis typically have a $1,000 denomination and trade in large blocks. ETFs are the answer to all these issues.  You can buy as little as one share of an ETF (generally less than $100) during market hours and at the same cost as for a stock.   

 

You can hedge an investment and/or lock in gains using ETFs.  Unlike open-end mutual funds, ETFs can be bought on margin and shorted. Investing on margin can magnify your returns and your losses. The ability to short enables you to make money when something goes down in value. Think shorting the dollar or home building stocks. However, to paraphrase TV commercials, these strategies should only be employed by a professional driver on a closed course. It’s also important to note that you don’t have to short an ETF if you think an asset is going to decline in value. You can probably find an ETF which is structured to generate an inverse return to that asset. ProFunds Group has a number of ETFs designed to perform this way. So, for example, if you think the Chinese stock market will decline, you can purchase a ProFund which should increase in value if you’re right. 

All ETFs, even those which track the same index, are not the same. One S&P 500 ETF may weight its stock holdings by market cap, another may weight them all equally. This will result in different returns. Two ETFs which track the technology sector may hold different stocks and/or in different weightings. Since most indexes are not strictly defined, think technology versus S&P 500, there will be a variety of different investment strategies employed. Different strategies to mimic an index are not good or bad, but they may have different risk levels and will produce different returns. Some ETFs  also use leverage to enhance their returns or structure there holdings to magnify any gains (thus, also losses) of an index. You need to know what you’re investing in. To understand how a specific ETF works, visit its website and read its prospectus. Want to learn more about ETFs or take a look at some of the most popular? Go to I shares, Power Shares, or HOLDRs.

 

Within five years most investors will have at least one ETF in their portfolio. Also, within five years, there will be more money invested in ETFs than in open end index mutual funds. The advantages of ETFs – liquidity, transparency and lower expenses, to name a few – will force changes in open end mutual funds.  Happily, the investor will be the winner in the competition between these two investment vehicles.

Every investor should consider Exchange Traded Funds (ETFs).   The younger brother of open-end index mutual funds is growing up fast and showing greater versatility.

 

ETFs are open-end index mutual funds that trade like stocks (and closed-end mutual funds). 

 

There are three legal structures of ETFs: Open-end mutual fund (the difference between the ETF structure and a open-end mutual fund is the ETF is exchange traded, whereas the traditional mutual fund is purchased and redeemed by the fund itself), Unit investment trust and Grantor trust.   The open-end mutual fund structure has a diversification requirement, mandated by the Investment Company Act of 1940, which limit how it mimics some smaller or specialized indices and could result in a tracking error. The other principal difference for the investor is that other than the open-end mutual fund, dividends must be paid out in cash to investors (of course, you could reinvest them if you desired), rather than reinvested by the ETF. These structural differences aren’t significant for most investors. The more important question is whether it’s the right ETF for you in terms of what index it’s designed to follow. The index and dividend payout requirement are disclosed in its prospectus and most ETFs also have websites where you can find this information.

 

Tracking error is the difference between the return on the index the EFT is designed to follow and the actual return on the index. An EFT which holds all 500 stocks in the S&P 500, in the same weighting as the S&P 500, should have exactly the same return as that index, less fund expenses. That’s an easy one. ETFs that are created to track, say, the biotech stock index will have different interpretations of that index. A biotech ETF could weight all stocks equally, weight by market cap, hold big cap or small cap bio stocks, and so on. As a result, the ETFs performance will vary with the success of its strategy. A good illustration of this is in Biotech ETFs: It Pays to Shop Around, in the October 15^th BusinessWeek. The five funds BusineesWeek highlights had year-to-date return ranging from -3.7% to 27.3%.

 

ETFs are required to disclose their holdings every day, unlike mutual funds which only have to disclose once a quarter. However, this should not be a big deal because we’re dealing with index funds and the components of indexes should not change very often.

 

There are two aspects of ETF liquidity for investors to consider: the ETF and its index’s securities. Since ETFs trade like stocks, they can be traded all day long. Open-end mutual funds can be purchased or redeemed only once daily, after the market closes. You have to put your order in prior to 4PM (while the stock market is still open) or wait until the next day. The liquidity of the EFT – the frequency with which it trades and the depth of the market – is similar to a stock and parallels the size of the EFT. But ETFs also have a very unique feature, they can be expanded or contracted depending upon demand, see Share Creation/Redemption, which provides them with even greater liquidity. And, ETFs can be more liquid than the individual shares they hold, thus, providing investors with greater liquidity. This is especially true for an ETF that holds small cap stocks, which are thinly traded, or bonds other than US Treasuries, which trade infrequently.

 

Authorized Participants, think big banks who act as market makers or specialists on an exchange, trade market baskets of the underlying index’s securities to the EFT in exchange for new ETF shares, when the demand for ETF shares increases. The Authorized Participants then sell these newly created ETF shares on the open market. The process is reversed if there are more sellers than buyers of the ETF.  The purpose of this feature is to keep the ETF’s market price as close to its net asset value as possible. (The risk exists that the Authorized Participants would not, or would not be able to, perform this function during a market crisis. The result of this could be an ETF which trades away from its net asset value.)

The price at which the ETF trades is based upon supply and demand. Unlike the share of an open-end mutual fund which is purchased or redeemed at its net asset value (NAV), the price of an ETF share may trade above or below its NAV. By way of comparison, closed-end mutual funds often trade away from their NAV for extended periods of time. Unfortunately, many closed-end mutual funds trade significantly below their NAVs. The Authorized Participants provide vital role, through share creation and redemption, in keeping the price of the ETF close to its NAV.

The structure of ETFs gives the investor a tax advantage over mutual funds. Open-end mutual funds, even index funds, must sell shares of the stock they own to raise cash when redemptions exceed purchases. These sales can result in taxable gains and losses which are passed along to the investor. Thus, you could have a taxable gain on the fund you own, even though you didn’t sell it. The share creation/redemption process for ETFs shifts this liability to the Authorized Participant. If the Authorized Participant trades ETF shares to the EFT, it is responsible for the taxes on any gains if it sells the securities it received from the ETF. Of course, the investor is liable for any taxes when he or she sells an ETF or mutual fund. 

ETFs have lower fund expenses than index mutual funds, although the difference is usually only a few basis points. (Don’t be misled by ETF advertisements which compare their expenses to actively managed open-end mutual funds.) Theoretically, the expenses for an ETF or mutual fund structured to track the same index, assuming they’re roughly the same size fund, should be the same. 

 

Since ETFs are traded like stocks, the commission charged to buy or sell an ETF is similar to the commission on a stock trade. Index funds are no-load, and are commission free, although some charge a back-end fee if you don’t hold it for a certain period of time. The second cost to consider is the bid/ask spread. Even stock and ETF has one, although in most cases they’re very small, i.e., a few cents, unless the ETF is very illiquid. Transaction costs – none vs. some – favor no-load mutual funds over ETFs but the cost differential is slight

 

What are the uses and advantages of ETFs? Come back next week and I’ll tell you.

It’s hard to believe with oil approaching $100 per barrel, but the U.S. will consume over 1 billion (that’s 1,000,000,000) more gallons of gasoline in 2007 than in 2006. As a certain President once said, we are energy junkies.  We keep craving more regardless of the price.   Ask yourself this: Are you plugging more stuff into the wall each year? That requires even more oil, natural gas or coal. China, India and the other new economies also consume more energy each year.  Political instability in Nigeria, Iran, and Venezuela could limit supply. And, there’s only so much oil (natural gas and coal) in the ground. I’m not suggesting we’ll run out but it will become more expensive to extract it.

 

How can you ease the pain every time you fill up? Or better, how can you benefit from higher energy prices? By investing in energy companies. There are two ways to do this. You can buy a Natural Resources sector fund or you can buy a Value fund which holds energy stocks. The sector mutual fund is the “pure play.” It holds energy stocks and, probably, stocks of minerals i.e., iron ore and copper, mining companies. The risk with a sector fund is that there aren’t a lot of them to choose from and they aren’t diversified. Don’t get me wrong. A sector fund is diversified within its focus area, i.e., owns a number of energy and mining companies, but any fund which investors in only one part of the economy is inherently riskier then a broadly diversified mutual fund. The other way to “play energy” is through a large cap or mid cap value fund. These funds typically have some energy exposure. The downside of this approach is that value mutual funds have only a portion of their assets invested in energy stocks.

 

With either a Natural Resource fund or a Value fund (or any fund, for that matter), don’t just go by the name. Check the fund’s holdings to see if they match your expectations. Different fund managers view and approach their mandates differently. You can find a list of the top rated Natural Resource and Value funds and their top holdings at MUTUALdecision. You can drill down (no pun intended) further by going to the fund’s website for a complete list of its holdings.

 

Which investing approach is right for you? It depends upon how much risk you’re willing to take and how your other assets are invested (think diversification of your entire portfolio). Having an energy investment might ease the pain the next time you fill up.

Let’s dispel the notion once and for all that index funds are only for passive investors. Sure, the original index funds tracked the S&P and were meant for investors who either believed you couldn’t beat the market or didn’t want to try. Since their beginning, index funds have expanded their breath. You can find a fund which tracks any of the major indices and most industry sectors, such as health care and technology. The first cousin of index funds, Exchange Traded Funds (ETFs), do the same thing – they track indices. Between index funds and ETFs you can mirror any major index, small index, industry sector, industry sub-sector (i.e., biotech or software), global region or individual country. You can also try to outguess the indices if you want. For example, you can buy a S&P index fund which weights all 500 stocks equally or one which weights them by market cap, and so on. (Note to investors: make sure you know what you’re buying.) Thus far, we’ve only focused on equity funds but index and exchange traded funds also are available for fixed income securities. These funds are particularly suited for fixed income investments (Treasury, corporate or muni) because they can buy and sell bonds at much lower spreads than individual investors.

 

The proliferation of index and exchange traded funds means you can construct an entire portfolio of these funds to meet almost any investment strategy and risk level. A combination of a S&P fund, mid-cap and small cap domestic equity funds, foreign funds and fixed income funds of varying maturities, and a real estate fund would fit many investors objectives for a diversified portfolio with good growth potential and reasonable risk.

 

A mix of funds with individual securities or using a fund to fill a gap in your portfolio is an equally good idea. For the investor who wants to participate in, for example, biotech or emerging markets, a fund will enable her to achieve diversification in that sector (and the riskier the investment, the more important diversification becomes) with only a small investment.

 

Index funds can be bought and sold once a day; some ETFs as frequently as every hour. The larger funds are liquid investments and, in many cases, more liquid than their underlying securities (bonds and small cap stocks, for example). Transaction costs are modest, perhaps nothing for a no load fund (subject to certain holding period requirements) and typical stock commissions for an ETF.

 

So what’s the downside? There’s a body of academic literature and models which “prove”’ that a small group of fund mangers can outperform the market, think Peter Lynch and Bill Miller. If you believe this, and I do, or you just want to hedge your bet (I shudder as I write those words because investing is not a bet, it’s hard work and serious business), you can mix some actively managed funds in with your index funds and ETFs. The other issue you have to consider is that index funds/ETFs can take different investment strategies to for the same index. I gave the example above of two S&P 500 funds that are constructed differently. They will perform differently as a result. Structure and performance differences are even more pronounced as you invest in riskier/smaller indices. Taking biotech, for instance, one fund may broadly diversify, another may invest in the ten largest biotech companies, and a third may take a different investment approach. As a result, their performance will widely differ. So, again, make sure you understand your fund’s approach.  You can’t tell a book or a fund by its name.  Index funds and ETFs have a place in your portfolio; they’re no longer just for passive investors. 

 

Why could the U.S. be heading into a recession? The most likely reason is the housing market – a multi-faceted subject. There’s the new home building sector.  It’s important because it employs so many people, not just in construction but, by extension, in the industries that supply materials to the homebuilders – lumber, concrete, appliances, and even retailers like Home Depot. Think about all the “stuff’ that goes into a home and how much you buy when you move. A slowdown (or collapse) in new home building has a ripple effect throughout the economy and could drive up the unemployment rate. 

 

Housing market problems are not limited to new home sales. The value of your home and the market for sales of existing homes is falling. By how much and for how long is the big question. But the problem here is the equity we have in our homes is evaporating. Even worse, those of us who have recently purchased homes or have taken money out of our homes, through refinancing or home equity loans, may have no equity left. A reduction in home values reduces homeowners net worth, causing them to pull back on spending.

 

The mortgage market mess is the last, but the not least, of the housing market issues.   The big problem is not subprime mortgages, it’s adjustable rate mortgages. Bumps in mortgage payments due to contractual provisions or an increase due to a rising LIBOR rate – most mortgages are tied to this rate and it may rise even if interest rates fall in the U.S. – will force consumers to cut back spending in other areas.   Lastly, will more stringent lending standards exacerbate the new home construction and/or existing home value problems?

 

There are other economic concerns as well – consumer spending (beyond the impact of the housing market), rising energy prices, the U.S. balance of trade deficit (are jobs being exported as a result?) So, if you’re concerned about the possibility of a recession, and who shouldn’t be, how do you invest?

 

The stock market, according to classical wisdom (or folklore) anticipates a recession by six to nine months. Since it’s currently at record highs (at least the Dow and S&P) this suggests a recession is not in the offing. But the market could change direction at any time. There’s a saying that the stock market has predicted ten of the last five recessions.   So maybe it’s not such a perfect predictor after all. The stock market also anticipates economic recoveries.  Add to the mix the psychological difficulty of investing in stocks when things are the bleakest (the best time to buy) and it demonstrates the difficulty (impossibility, for most of us) of trying to time the market. 

 

Most investors should be in the stock market to take advantage of growth in principal value and income which comes through the long term ownership of equities. Stocks which do best in recessions are those of the strongest companies and companies whose products consumers must keeping buying (think toilet paper not cars). The stocks to focus on are big cap companies, consumer staple products and health care. There’s an overlap between many big cap stocks and consumer staples and health care companies. I’d also add to this list companies with significant international sales. (Did you know that a majority of McDonald’s, and many other U.S. companies, sales are overseas?) There’s also a substantial overlap between big cap and international sales. You can find many good mutual funds which focus on these areas.

 

Will this investment strategy provide a positive return during a recession? Not necessarily but it will keep you in the stock market with a minimum amount of risk and the long term investor will be well positioned if there is no recession or for the upturn in stocks after the recession occurs.

 

What about bonds, you ask.  Don’t they do well during a recession? Yes, if interest rates decline as a result, but that may be occurring just when stocks are beginning to rally again. With long term U.S. Treasuries yielding below 5% (some good money market accounts have higher yields) how much lower can interest rates go, so how much higher could bond prices go? Focus your risk-taking investments on the stock market and keep the rest of your capital in cash.