Manage Your Risk and Boost Your Profits, Even in a Volatile Market

If there’s one key to investing success, it’s this: Manage your risk.

If you take special care to protect the profits you have, and to keep your losses to a minimum, you’ll find that you can maximize your long-term profits. It’s a message I convey time and again. In fact, I just returned from the Agora Financial Conference in Vancouver, where I had the pleasure of presenting to packed audiences. I also especially enjoyed getting to speak to some of the other presenters – it’s always good to trade ideas and to hear what other analysts are thinking. And while I always present my market overviews at these events – and take pleasure in doing so – I make sure to remind investors of the fundamental rules for success and profit in stocks.

And don’t think that I ignore these fundamentals myself. Not a chance. Indeed, my strict adherence to these time-proven rules allowed some of the subscribers to my trading services to keep their short-term profits, and position themselves for some very nice long-term gains. Allow me to tell you what happened.

In several of the financial services that I manage, we completed our portfolio review and profit-taking several weeks ago – well ahead of the recent sell-off and ensuing volatility. I’d like to outline some of the broader moves we made, as well as the strategies behind them, and then tell you what to be looking for in the days and weeks to come.

Since that timely portfolio review, we’ve seen a large sell-off in energy stocks – despite the fact that crude oil keeps trading higher. Just yesterday (Thursday) crude oil traded above $77 a barrel and was within sight of its record high.

In fact – as if to ignore the spiraling price of crude oil – we’ve seen a large sell-off in energy stocks of late. And while oil prices rise, natural gas and gasoline have been weakening. Believe me when I tell you that oil is vulnerable to a strong correction, given the ample supplies in the absence of hurricanes (absent this season) or a troubling geopolitical event. With respect to the latter, Iran seems to be "behaving" better recently, although I would not count on this continuing.

We sold all our positions in which our short-term upside was very limited – and where we had sizable profits. And we kept the positions that had a very limited downside, but which also still had huge upside potential.

The bottom line: We ended up being very well protected against the ensuing market sell-off, and we avoided any major losses in our portfolio of stocks.

Let’s now look at what’s to come…..

The Credit Crunch

As we anticipated, ongoing concerns about the sub-prime mortgage problems are creating better buying opportunities in some sectors, and in some stocks. With the recent widespread losses a number of major hedge funds and financial institutions were forced to take because of sub-prime related investments, these major players were forced to de-leverage – a maneuver that forced them to raise cash by selling unrelated assets. These losses not only left these players with less capital to carry existing positions, it also left them with less capital to lend.

This is Economics 101: With a reduction in the available supply of credit, the price of that credit increased. And the price of that credit is its interest rate. We saw this play out across asset classes. For example, even though the yield on U.S. Treasuries achieved new recent lows, the rate on 10-year mortgages INCREASED. Similar effects were felt in the riskier spectrum of the debt markets, leading to a general re-pricing of credit spreads for the worse.

Add in the fact that banks are having problems placing key financing deals like the Cerberus Capital Management loans for the leveraged acquisition of automaker Chrysler, and you get the picture: The flow of liquidity that was financing these massive takeovers – while still there – has slowed, and is now more expensive.

All of this translates into lower expected equity valuations, as well as a slowdown in takeover activity for the future. Hence, the virtuous cycle of takeover pressure – which forced CEOs to either buy out other companies, or aggressively buy back their own stock to avoid becoming a takeover target themselves – is lessened.

Higher credit spreads also mean slower future economic growth, since it makes capital pricier and less available to Corporate America.

This combination of factors also shows a disruption in credit markets that at a later time might catch a big player off guard, creating a large default risk. Should something that significant occur, the Federal Reserve would likely have to step in and lower interest rates to stabilize the financial system – just as it did with the September 1998 rescue of Long-Term Capital Management, the vaunted hedge fund founded and run by Nobel laureates. But this time around, the Fed probably wouldn’t step in until after much pain had already been suffered.

In the meantime, I’m glad to see that the central bank is doing yeoman’s work, slowing inflation via higher credit spreads. And speaking of inflation…. it clearly must be getting closer to the Fed’s “secret” rate-reduction trigger point – whatever that might be – as the economy’s core PCE is about 1.4%, well within the Fed's so-called “comfort zone” of 1% to 2%.

At the end of the day, the fundamentals are still very good for the U.S. economy. But our anticipated second-half recovery will be a bit-less pronounced than we’d hoped for – a new reality that justifies the market correction we saw.

Markets to Watch

Investors can still profit, however. For instance, companies that are awash in cash and that do not need to tap the credit markets for costly additional capital right now will continue to march forward. Focus the closest on large-caps, high-tech firms, non-cyclicals, and those that pay high dividends.

U.S. companies are awash in cash, which is a key reason the government’s second-quarter Gross Domestic Product (GDP) report said there’s been a strong pickup in investment spending by businesses, which we’d earlier said to watch for. With that boost from business spending, high-tech companies in particular should enjoy a very strong second half of the year. Given that global competition is as intense as it’s ever been, U.S. companies will need to ratchet up their labor productivity to outpace their rivals from abroad, and the best way to do that is via high-tech investments. We are also at the very beginning of a new PC upgrade/replacement cycle, thanks to the new Microsoft Corp. (Nasdaq: MSFT) Vista operating system.

These new PCs will house new generations of the more-powerful dual, quad and octo chips built by Intel Corp. (Nasdaq: INTC) and Advanced Micro Devices Inc. (NYSE: AMD). These powerful processors will easily handle the anticipated massive surge in streaming video, data-laden telecommunications services, and other bulky applications that will be making their debut in the months and years to come.

International markets, too, hold much promise. One market we like is India, although there’s a challenge to overcome: It can be quite difficult to find opportunities to buy quality names at reasonable valuations there. But it’s better to wait – and buy at bargain prices – than to jump the gun, expecting instant satisfaction.

From an investment standpoint, Brazil represents an outstanding opportunity. The world’s seventh-largest economy and one of its four promising “BRIC” economies – Brazil, Russia, India and China – Brazil is a market that I know very well. This may well be your best chance to invest there.

Over the past decade, Brazil has transformed itself into one of the most-dynamic growth economies on the planet. The country has rock-solid fiscal and monetary policies, as well as a proven ability to meet inflation issues head-on – and defeat them.

But what’s really exciting about Brazil is the fact that the country is at the forefront of a massive consumer boom that is about to ignite economic growth and unleash a torrent of corporate profits.

And investors should not turn their backs on the U.S. market, either. While we are undergoing a correction of the less-than-ration “credit exuberance,” the fundamentals of the U.S. economy are still very strong. The only problem is that it will be almost impossible to say when this troubling problem will end, enabling the financial-services sector to halt its slide, rebound, and then race for higher ground – a prediction we analysts refer to as “calling a bottom.” Ideally, we’d all like to know just when the market bottoms out, so that we could go in and scoop up stocks at the bargain-basement prices.

Unfortunately, it’s clearly premature to “call a bottom,” given that the de-leveraging process that needs to take place usually takes some time to play out. And it will. But in the meantime, we must follow some very careful defensive-investing strategies. We’re also starting to see some much-more palatable valuations in the stocks that are on our “candidate” list – the ever-evolving list of stocks that we’re keeping an eye on for possible purchase. At some point we are going to start adding new positions, as the price of these shares fall enough to reach our “buy” points.

Until then, stay tuned.
Horacio R. Marquez is an Advisory Panelist for Money Morning, and is also the Investment Director of The Money Map Report. Marquez also operates several proprietary-trading services.

 

Tags: Investment Experts, Risk Management