Hang on to your stocks but cut back on risk. By Jeffrey R. Kosnett, Senior Editor March 25, 2008 A bloodthirsty bear will shred share prices for another year, maybe longer. Or perhaps the Federal Reserve's rapid interest-rate reductions will quickly calm the financial world and set the stage for the next rally. You can argue either case. But rather than trying to forecast the markets, you'll make better use of your time by focusing on how to protect your retirement funds and other savings through what is sure to be a lengthy period of fear, uncertainty and doubt.Defensive investing is not about moving all or nearly all of your IRA and 401(k) money to cash or bonds. That may be a wise move if you're a year or two from retirement and have accumulated enough wealth to last the rest of your lifetime. But for most people, hunkering down in low-risk investments is not a particularly attractive option when bonds and money funds yield 3% or so (although, truth be told, even tiny returns are better than losses). RELATED LINKS The Big Picture Isn't Pretty Protect Your 401(k) in Troubled Times Advice for Rough Times Long-term investors should keep 60% to 70% of their investments in stocks and stock funds. Recalling that stocks lost nearly half of their value in the 2000-02 bear market, which coincided with a recession, you may think we're being overly aggressive or optimistic or both. But let's put these wobbly markets -- the current one and the one earlier in the decade -- in perspective. At the outset of the 2000-02 conflagration, stocks (particularly technology stocks) were in the stratosphere. But back then, you had good alternatives. Both oil and real estate, for example, were depressed. Today, by contrast, few stocks trade at absurdly high levels, and gold, energy, other commodities and even Treasury bonds look pricey. Keep the rest of your portfolio in low-risk investments, such as a money-market account or short-term bond fund. That will provide ammunition for a bargain hunt once you get a sense that the U.S. economy is nearing a bottom, probably later this year or early in 2009. And the bargains are starting to proliferate. As of mid February, the Nasdaq Composite index was already in bear-market territory, having dropped 20% from its October high; the broader Standard & Poor's 500-stock index was off 16%. Advertisement Clearly, markets and the economy are shaky, so you should cut back on risk. Speculative stocks and junk bonds are for another time. Developing nations such as China and Brazil are still growing rapidly, but their stocks are dangerously expensive. Stay away from those kinds of markets until they correct. Cut out or cut down on stocks that depend on lavish U.S. consumer spending or a fast housing recovery. The bear is growling most fiercely at companies that so much as hint that customers might be backing off. Case in point: In January, Apple (symbol AAPL) reported awesome Christmas sales and record profits for the October-December quarter, and the company introduced some flashy new products -- but the stock lost 19% in a couple of hours. It was down 37% year-to-date through mid February. Why? Because Apple said the rest of the year would be merely good, not spectacular. Shaky psyches Some pros think the mood of investors is a bigger problem than the actual economy. Outside of real estate and the financial sector, there haven't been unusually large numbers of profit warnings, dividend cuts and other signs of serious distress. "Companies are fine," says Kelli Hill, who manages growth-stock accounts for Ashfield Capital Partners, in San Francisco. "It's the market that's a little shaky." Hill has a point. Through early February, 64% of all companies that had reported fourth-quarter results had exceeded analysts' estimates; 11% matched forecasts. Excluding financial companies, fourth-quarter profits rose an average of 18% from the year-earlier period. Companies delivering surprises on the upside were a diverse lot, including IBM (IBM), MasterCard (MA), Thermo Fisher Scientific (TMO) and Whirlpool (WHR). Each of those stocks has outpaced the S&P 500 since the market peaked last October. There's no reason to dump the shares of any company that is growing, has been making its numbers and does a lot of business overseas. And never sell in a panic, especially at the very end of the business day. Since July, the S&P 500 has lost 1% or more on 35 different days. In 71% of those cases, stocks rose the next day. Advertisement What should you do? For starters, stick with your long-term investment plan. If you're young and saving for retirement, keep directing your IRA and 401(k) contributions toward stocks -- over the long run, you'll gain from steady purchases of stocks and stock funds by buying on weakness. Look for beneficiaries of lower short-term interest rates, stay with companies that are strong exporters, and hunt for dividends. Ian Delaney Doherty, a 35-year-old architectural designer in Falls Church, Va., is this sort of big-picture thinker. He's still rankled by the loss of half his savings when tech stocks crashed. Doherty reconstructed his IRA over several years and recouped his losses with funds and stocks in steadier sectors, such as investment management and utilities. He also added international funds, including Russia and Brazil funds, which he shrewdly bought in 2004. But since October, when questions about the health of the financial sector again began dominating the news, Doherty has reduced the risk in his portfolio, primarily by selling his emerging-markets funds and raising cash. He doesn't expect to stay in cash for long, how-ever. "It's my dream to make money in a down market," Doherty says. Toward that end, he's scoping out large, powerful U.S. companies with global reach. Among his potential prey are AT&T (T), Cisco Systems (CSCO) and Pfizer (PFE). If you do take risks now, do it only with money you can afford to lose. Tim Byrnes, 50, a technical director for AT&T who lives in Jackson, N.J., has 70% of his 401(k) in stocks and 30% in bonds. He also has a small taxable account in which he is willing to experiment. After a wonderful 2007, Byrnes lost 16% in the first two weeks of 2008 as his holdings in small tech companies collapsed. Byrnes could have frozen or cashed in what was left. Instead, he made some sensible changes. Noting the Federal Reserve's interest-rate cuts, he sought investments that get a boost from lower short-term borrowing costs. One is Annaly Capital Management (NLY), an unusual real estate investment trust that borrows at short-term rates, uses the proceeds to buy higher-yielding, long-term government-backed mortgage securities and pays out as dividends nearly all of the profits from these interest-rate differentials. Byrnes also invested in MFA Mortgage Investments (MFA), a slightly racier rival of Annaly. Both gained more than 12% in the first six weeks of 2008. As long as the Fed keeps signaling its intention to cut rates, these kinds of REITs are good places to park cash and get good income. Byrnes also reasoned that a recession would bring down oil prices, so he bought shares of Midwest Air Group (MEH) in mid January. The stock has climbed 21% since then. Advertisement Rotating into stocks of companies that tend to hold up well in feeble economies is part of defensive investing, but you can also take some nuts-and-bolts measures to protect your gains. For example, financial planner Donald Duncan, of D3 Financial Counselors, in Downers Grove, Ill., suggests using stop-loss orders on individual stocks or exchange-traded funds. With a stop-loss order, you set a target below a stock's current price. If the stock drops to that price, your broker is obligated to sell it. Stop-loss orders are particularly helpful if a stock is in a gradual decline. They're not as successful when a stock crashes and blows right past your stop price. The other drawback is that you can get "stopped out" of a stock that's still a long-term winner and become liable for capital-gains tax. Stop orders are therefore more appropriate for tax-deferred accounts. Funds for hedging Duncan also suggests hedging by placing 5% to 10% of your money in a fund designed to perform well in a poor market. Prudent Bear (BEARX), which bets that stocks and the U.S. dollar are heading down and gold prices are heading up, is for die-hard pessimists. In 2008 through mid February, Prudent Bear gained 6%, while the S&P 500 lost 9%. In 2002, when the market tumbled 22%, Prudent Bear soared 63%. But because the buck has already plunged and gold is at record levels, you might want to hedge with investments that are more mainstream. A handful of quirky funds have good track records at making some money in up markets and protecting their shareholders in down periods. Hussman Strategic Growth (HSGFX) is the class act of this group. Manager John Hussman uses options and other defensive techniques to protect against declines when he thinks the stock market is in trouble. He removes the hedges and buys mostly blue-chip stocks when he thinks sellers have gone too far. Granted, there's an element of market timing in Hussman's process, but his record is reassuring. In 2001 and 2002, both down years, Hussman's fund returned 15% and 14%, respectively. Since the fund's launch, in 2000, it has never lost money in a calendar year or dropped more than 2.3% in any quarter. Advertisement Brokerage firms and investment advisers produce lists of stocks to own during a recession. The rolls are typically filled with grocery chains, energy companies, utilities and makers of drugs, food and soap -- providers of the essentials of life. But this recession, or near-recession, is different. Procter & Gamble (PG) is a solid company, but its shares are down 12% in 2008, despite steady but unspectacular growth by the consumer-products giant. There's nothing wrong with holding P&G for eternity, but it's not impervious to either a recession or a bear market. Neither is ExxonMobil (XOM), another traditional safe haven. As crude-oil prices have trended down, Exxon's shares have fallen and are now off 13% in 2008 through mid February. Stocks of other big energy companies have been faring even worse, reflecting not only the oil-price outlook but industry problems. Global oil giants are struggling to find new supplies while dealing with unreceptive governments in countries new to the energy scene. Stocks have lost at least 14% before and during every recession since World War II. But what's happening today has no recent precedent. In the past, you only had to wait for Congress to cut taxes and the Federal Reserve to trim interest rates, and before you knew it, stocks were off to the races. This produced marvelous buying opportunities in 1974, 1982, 1991 and 2002 -- particularly for bank stocks, which historically rally in response to lower interest rates and have led the way at the outset of new bull markets. But the picture is murkier now, as bond guru Bill Gross notes in an interview with Kiplinger's. Because of their exposure to subprime mortgages and other bad debts, many banks are hurting and are tightening lending standards. Also weighing on the economy are falling home prices, expensive oil and high levels of consumer debt. The market's lukewarm reaction to the Fed's sudden rate cuts is evidence that this isn't just another cyclical downturn. Given the seriousness of the country's economic problems, it's a wonder stock prices haven't fallen more. The reason they haven't? Even as some sectors of the economy perform poorly, others are doing just fine. Banks have problems, but most insurance companies do not. Homebuilders are in a depression, so Whirlpool is suffering -- in the U.S. But the company is selling so many ranges and refrigerators abroad that it reaped record sales and earnings in 2007 and blew past analysts' estimates. Its shares have gained 10% so far in 2008. Transportation would seem to be an area to avoid now, but exports of products such as coal and grain remain strong, which is good for shippers. Lower fuel costs are a possible bonus. Railroads, such as CSX (CSX) and Kansas City Southern (KSU), are good bets. What's more, they benefit from firm pricing. FedEx (FDX) and UPS (UPS) are also beneficiaries of lower fuel costs. Their shares fell in 2007 but have been gaining since oil prices started to slide from $100 in early January. Health care is another traditional refuge from recession, but you have to choose carefully. Most big brand-name drug makers are short of new drugs. One exception is Eli Lilly (LLY). Costly medical and orthopedic gadgets may find fewer takers in a weak economy, but generic pharmaceutical makers benefit from a flood of expiring drug patents and the need to cut health-care bills. Shares of Teva Pharmaceutical Industries (TEVA), the global leader in generics, are reasonably priced, although the Israel-based company faces challenges from larger drug companies that are moving into generics. Finally, high dividend yields smooth out the bumps. Skip high-yielding bank stocks, however. As Citibank and Washington Mutual demonstrated recently, bank dividends are vulnerable. Property-owning REITs are starting to recover from a terrible 2007, but wait for the economy to expand again before jumping into them. Many other stocks pay more than REITs do anyway. Natural-gas royalty trusts, such as San Juan Basin (SJT) and Cross Timbers (CRT), or just about any pipeline partnership, such as Magellan Midstream Partners (MMP), are relatively safe as well as profitable. Yields range from 6% to 12%, and you'll suffer only a little price erosion, or none at all, if energy prices continue to fall. The price of natural gas, in particular, looks poised to rise. But until that happens, the chemical industry, which uses gas as an ingredient, looks attractive. Stocks such as Dow Chemical (DOW) and DuPont (DD) pay good, secure dividends.