Why Now's the Time to Get Defensive(zt)

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Why Now's the Time to Get Defensive

By Todd Wenning
January 13, 2010

Do you hear that?

To steal a phrase from Simon and Garfunkel, it's the sound of silence in the market. And it's making me nervous.

Remember just 12 months ago, when the CBOE Volatility Index, the "VIX," was comfortably over 40, implying significant investor uncertainty? Those were indeed scary times, a few months after Lehman Brothers collapsed in September 2008, but as an investor I was actually more comfortable then than I am right now. There were a lot of great stocks on sale!

You haven't heard about the "VIX" for a while now because, guess what, it's back below 20 -- implying investor complacency. We haven't been this low since (gulp!) August 2008, before the Lehman Brothers debacle.

Scared yet?
Even though the stock market has charted a steady upward course since last March, I have a hard time believing that all is well enough in the global economy to justify complacency.

That's why now is the time to get defensive. That means:

• Having cash available to invest.
• Considering options strategies to protect your gains.
• Building a watch list of stocks you'd want to buy at 10%-15% below current prices.

Traditional defensive maneuvers would typically include increasing your bond exposure, though with yields so low and interest rates inching higher, I don't think this is a great place to put new money right now.

My best friends call me "Cash"
Thanks to the government's policy of low interest rates and quantitative easing, there's been (by design) little reason to hold a lot of cash. That's helped fuel both the bond and stock markets, as investors looking for even a tiny profit needed to put their cash to work somewhere.

Still, cash isn't trash and there's simply no substitute for quickly seizing opportunities in the market. If you're 100% invested and the market loses value, you need to sell something (at a lower price, of course) before you can buy anything else. That's a tough position to be in when stock values become much more attractive.

In our Motley Fool Pro portfolio, for instance, we took advantage of last year's market downturn by using our cash to pick up solid companies like Intel (Nasdaq: INTC) andAutodesk (Nasdaq: ADSK) at very attractive prices. Today, we've strategically left a large cash balance in the portfolio to grab future bargains the market may throw our way.

Yes, you have options
Market volatility plays a major role in the pricing of options (calls and puts). This is because investors perceive "risk" as volatility and when volatility is low there's simply less demand from options buyers (who have the right to buy and sell a stock) who seek to improve returns with big moves in stock prices.

All of this is to say that when options prices are low and the market's been rallying, considerprotective puts on stocks and exchange-traded funds that have made you big money.

Let's say you bought 100 shares of SPDR Gold Trust (GLD) ETF in November 2008 for $75 -- a $7,500 investment. The ETF currently trades for about $113 -- a nice 50% gain for you. By purchasing a March $110 put for $2.75, you can lock in a sales price of $110 for your 100 shares through March 19, 2010, for $275 per contract.

One scenario: The ETF doesn't fall below $110 by March 19 and you're out $275 (4% of your original investment). But hey, you can still enjoy any upside left in the ETF. The other scenario: The ETF falls well below $110, but you can still sell for $110 (minus the $2.75 per-share cost) thanks to the protective put you bought.

Think of buying protective puts on your big winners as insurance against the chance of losing those gains in a market downturn. Even though you may grumble when you pay the premium for the put, just as with your auto insurance, you'll be glad you did if something bad happens. At the very least, it can give you some peace of mind in an uncertain market.

Make a list, check it twice
U.S. stocks have made a huge recovery from their March 2009 lows, and while I don't think they're anywhere near bubble territory, good values have become harder to find. That doesn't mean you should stop researching, though.

Here are five S&P 500 stocks with returns on equity over 15%, price-to-free cash flow ratios below 20, and manageable debt levels -- in other words, strong companies worth buying if the market does take a downturn.

Company	Price-to-FCF	Return on Equity	Total Debt to Equity
Coach (NYSE: COH)	15.9	38.7%	1.37%
Gilead Sciences (Nasdaq: GILD)	16.0	49.4%	24.40%
Cisco Systems (Nasdaq: CSCO)	18.0	15.2%	25.70%
Stryker (NYSE: SYK)	18.3	17.7%	0.30%
Automatic Data Processing (NYSE: ADP)	17.1	25.4%	0.70%

Data provided by Capital IQ, as of Jan. 12, 2010.

Great companies don't always make great investments -- they still need to be bought at the right price.

Cisco Systems, for instance, has doubled its net income over the past decade, but remains 50% off its January 2000 prices. That's because investors were paying too dearly for Cisco's prospects during the dot-com bubble and, even though Cisco is a much better company today than it was in 2000, its 10-year stock chart doesn't reflect this progress.

That's why it's so critical to buy great companies only at the right prices. Another market dip could give us that opportunity, so prepare yourself now with a good watch list.