Using ETFs To Hedge Your Portfolio
The Dynamic Wealth Report
July 1, 2009
How To Hedge Your Portfolio From Tomorrow's Unknowns
by Corey Williams, Editor
Last week I was deep into research for the July issue of Sector ETF
Trader when I was taking a moment to gather my thoughts. I turned my
attention from my computer to the television. As usual, it was tuned
onto
CNBC. I turned up the volume and started listening to the talking heads.
And much to my surprise, there was a coherent and articulate debate on
the money supply and inflation.
The Kudlow Report was hosting two economists. One is sure we’re headed
for high inflation, while the other contends inflation doesn’t pose a
threat at all.
These contradictory viewpoints make investment choices difficult to say
the least. The smart money is hedging their portfolios against the
downside presented by either side of this argument.
Here’s what you need to know.
The economist decrying inflation gave this simple example, “… if you
have a huge increase in the supply of apples, the price of apples falls.” Applying this argument to the monetary base means an increase in the
supply of money decreases the dollars purchasing power, which is
inflationary.
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The other economist countered with, “If people suddenly want to hoard
apples and the apple suppliers provide a lot of apples, you’re not going
to have inflation of apple prices.” The argument here is banks are
hoarding the money instead of lending it. Hoarding money doesn’t
increase the money circulating in the system, which isn’t inflationary.
Who’s right?
Let’s start with the facts. The monetary base has grown by a jaw
dropping $858 billion in the last year. At the same time, the amount of
excess reserves on bank’s balance sheets grew by $842 billion.
Most of the increased money supply is sitting on the sidelines. As long
as it sits there, it’s not going to cause inflation. But when banks start
lending again, watch out. It’s a proverbial powder keg.
The only way the Fed can keep inflation from exploding is by reducing
the money supply.
But here’s the problem. The Fed is stuck between a rock and a hard
place. In order for the Fed to remove this excess money supply, it would
need to sell $800 billion worth of treasuries. And that’s in addition to
the $3+ trillion they’re already on the hook to sell in 2009.
If the Fed dumps an additional $800 billion in treasuries, it will drive
up interest rates. This will be a huge blow to the economy. I don’t see
them sacrificing economic recovery to keep inflation in check.
So what does all of this mean to your investing strategy?
The risks favor a high rate of inflation over the next 3 to 5 years. But
there’s always the possibility the Fed will remember its true purpose
and decide to preserve the purchasing power of the dollar. If it does,
the world economy could enter a prolonged period of little or no growth.
You can do a few things now to hedge your portfolio against either
inflation or stagnant growth.
The oldest and best way to hedge against inflation is gold. If you don’t
already own some, now’s the time to buy. Remember, you’re not investing
in gold to get rich, you’re trying to avoid going broke. The SPDR Gold
Shares ETF (GLD) provides an easy way to add gold to your portfolio.
Hedging against stagnant growth gets a bit trickier. In my opinion,
non-cyclical companies paying a nice dividend are the best way to go. In
particular, I like the utilities because of their steady revenue and
dividend payments.
There are a host of different ETFs focusing on the utilities sector. The
Vanguard Utilities ETF (VPU) is a good choice. VPU has a small (even by
ETF standards) expense ratio of 0.25% while paying a 4.52% dividend
yield.
The inflation debate will continue on. In a perfect world, economic
growth will return and the Fed will pull the money supply out just right
so we don’t have high rates of inflation. But I’m not willing to go for
broke. Hedge your portfolio now against a less than perfect economic
recovery.
• Uranium ($52 per pound)
Uranium’s not a commodity we talk a lot about. The trading on the NYMEX
is thin and it’s a relatively new market. Right now, prices are almost
one third of where they were just a year ago. This doesn’t bode well for
miners… However, the power plant operators should be jumping for joy.
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