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There is nothing new about expecting financial markets, especially in riskier assets, to have a correction soon. This topic is being discussed often and everywhere.
Of course nobody can predict exactly when it will happen or how it will play out. Many technical indicators such as sentiment and chart patterns as well as fundamental indicators such valuation and rising interest rates suggest a correction in risky assets could happen sooner rather than later.
Since short selling is a very tricky way to make money, especially when the market trend currently is up, what interests me more than exactly when or how the correction will happen is how to take advantage of the correction as a buying opportunity.
Toward that end, I am keeping at least 40 percent of my portfolio in cash so I have the liquidity to do some significant buying after the market has corrected. The remaining 60 percent of my portfolio is in assets that I believe are both a long term hold and are somewhat less vulnerable to a general decline in markets.
One camp of bears would suggest that owning more bonds, especially Treasuries, is a good way to benefit from a correction.
However, Treasuries are facing some major headwinds right now between a strengthening economy, quantitative easing and a looming battle about increasing the debt ceiling.
Other typically safe haven investments also have serious issues. Gold and other precious metals are extremely overbought and vulnerable to a correction. Further, a renewed interest in stocks, improved tax and regulatory environment and better prospects for the dollar all indicate trouble for precious metals. Municipal bonds face a wave of potential defaults or other crises resulting from state and local funding gaps as well as a growing movement in Washington to limit their tax exempt status.
Looking at all the alternatives, my analysis suggests that high quality dividend paying stocks, especially in the energy and utility sectors, are probably among the safer ways to prepare for this coming correction. Valuations are low, dividends are high and tax advantaged, and fundamentals are strong. If the broad market such as the S&P 500 corrects 10 percent, these stocks may only decline 5 percent. The easiest choice to follow this strategy is just to buy the SPDR Utility Select ETF (XLU). It pays a 4.1 percent dividend and is the lowest beta and most undervalued sector ETF in the market right now.
After the correction does happen, I’m expecting new leadership in the market. For the past year, leading sectors have been high multiple, high growth technology firms, small mining companies and small emerging markets.
The new leadership should rotate into larger and more value oriented companies in a more diverse group of sectors including technology, mining, materials, industrials, and health care.
The easiest way to take advantage of the buying opportunity created by the coming correction either would be to just buy the Nasdaq 100 (QQQQ) or S&P 500 (SPY). Another slightly riskier and more complicated way would be to buy iShares sector ETF for technology (IYW), the SPDR ETFs for mining (XME), materials (XLB), industrials (XLI), and health care (XLV).
Another sector that could be a good opportunity after a significant correction, is REITs. This sector is highly volatile, but it does have improving fundamentals, reasonable valuations and good dividends.
The iShares REIT ETF (IYR) pays a 3.5 percent dividend, but it isn’t tax advantaged like other stock dividends. REITs have also been significantly higher beta than other dividend paying stocks such as utilities. They trade more like financials, but with much better fundamentals, balance sheet transparency and dividends. For these reasons, REITs are actually a better way to play an improvement in the financial sector than buying banks. I think REITs will continue to do better than most other financial stocks.
It’s very likely that this year is going to have very different leadership in stocks as well as other assets than last year. Hopefully these ideas are helpful in navigating what will continue to be a surprising and challenging market environment.