How to Manage Market Volatility and Its Impact on Your Portfolio

Recently we talked about the imperative that short term leveraged traders focus on their risk with renewed vigor. The times make the trader and these are the most volatile, uncertain times of our generation.

Leverage is the unique apparatus of free markets that does something better than even the most confiscatory of tax men. Leverage redistributes wealth. Many of the mighty have indeed fallen. If we use our heads and think rationally - with a cunning ruthlessness in our trading decisions - we can replace a few of those former titans with ourselves.

What about those who are classified more as investors than traders? The most frightening stories of the market's recent implosion have been the immense losses suffered by ordinary investors. Many were seeking not market riches but instead just a percentage point or two of higher returns than the skinny yields offered by Treasury securities or insured deposits. This writer is hearing daily about folks who were in high yield money market accounts only to be informed that those funds are now frozen due to redemption pressure or in worse case locked up in receivership. I suspect the worst is far from over.

As a gun slinging futures trader who grew up in the age of plenty, I paid little heed to the sages who advised a balanced investing approach. My view was to put it all in one basket and intensely watch that single basket. Not all of us thought have the inclination, time or talent to monitor markets on a tick by tick, minute by minute basis. Not to mention as I warned in an earlier article, many short term traders actually have a negative expectation of return.

Yes, less is more but by definition less also means limited flexibility and agility. Since position sizing is of paramount importance and because we don't ultimately know what the right macro play will be - it pays to spread things out. A little here, a little there and a little tucked away on the side. For those who are trying to preserve capital yet hedge themselves against a myriad of unexpected outcomes I come to you in preach of diversification.

None of us should take for granted that the most extraordinary events imaginable cannot come to fruition. Short of the sky falling - and a few climate theorists will argue even that is possible - I hold no assumption or belief with a total degree of certainty. Many accepted tenants of the investment world, such as the saw that stocks and real estate offer outstanding long term returns are based on limited data and inflicted by survivorship bias. Each of us needs to take a hard, almost cynical look at our assets - including cash - and assess the worse case liabilities that are intrinsic to the reward side of the same coin.

My own trading methodology makes heavy use of fractal analysis. I'm constantly building "what if" scenarios based on past historical events. Often my positioning is nothing more than hypothesizing that if A occurs, then B can follow. We are clearly in a rapidly changing environment where a few different synopses may develop.

Let's briefly examine several popular asset classes and I'll divulge what I perceive to be the range of possibilities. It is then up to you to consider how balanced you are and what preparations you need to engage in case several "what ifs" were to negatively impact your total portfolio. Because we don't know if we'll see depression, inflation, stagflation or a rapid transition from one to another, we once again want to spread it out and be covered.

Like many of you, I too hold a few market biases. I tend to lean in the direction that traditional assets are overpriced, essentials under priced and that government guaranteed entitlements will pressure global fixed income and currency markets. With my prejudices in mind we'll discuss a few markets.

Stocks have undoubtedly benefited in the long run from inflation and currency debasement. The more it costs for a can of Coke, the higher we presume KO's earnings. That's not to say those earnings will keep pace with inflation. Nor can we state as in the case of GM that other factors such as cost of production or future liabilities won't negate higher unit costs. Usually though against a macro inflationary backdrop a basket of stocks will hold their own.

The short term inflationary downside: Inflationary pressures result in increased output expense, amplified borrowing costs and those higher yields vis-a-vis an inflationary milieu will draw investors away from stock purchases and into fixed income securities. A plausible consequence of this economic crunch will result in rapidly diminished industrial output, followed by an inflation charged shortage of manufactured goods during the subsequent recovery.

What about deflation? How low can stocks go? Two fractals I'm using suggest the low is in. Both the 1938 and 1974 lows were similar percentage moves to this 2007-2008 collapse. The fly in the ointment? I'm extremely dismayed by the situation in Japan. When the Nikkei broke 85% from 1989-2002 and then tripled in the ensuing 5 years, there was scant fractal evidence that the Nikkei could make a new multi decade low once again.

Could the S&P perhaps "fill in" prices going back to 1994? Because of the Nikkei, I'm quite open to a further plunge. If another 50-60% meltdown in stock prices will savage your retirement or lifestyle, then you are too heavily weighted in equities. If you're in cash waiting for opportunity then instead of going all in-scale in. If you dedicate 10% of your capital to a stock and it bounces 20% - a frequent move in this volatility - you've just increased your portfolio's value by 2% without taking a ton of risk. Also keep this in mind: if a stock goes to zero it matters little if you loaded up at 60 or if you waited until it was 20.

Real Estate: Housing contains many of the same valuation variables as equities. Home prices too trade at a price earnings ratio. A historic rule of thumb has been a resale value of 10 times the yearly rental stream. If you own a property that you think is worth $300,000 but would rent for only $1500 per month then reevaluate the "book value" of your home. Regardless of comps or recent sales you're exposed to sharply lower prices.

Another factor completely unmentioned by the media is the future impact of property taxes. Is your municipality solvent? Are there laws on the books protecting you from an unprecedented emergency tax hike? Even if you are homesteaded or protected personally from higher taxes, what will the increased tax burden be to a new buyer? In many areas, including Florida tax bills on higher valuation, homes have effectively capped resale prices. If you own real estate then cut down on your equity holdings. Don't be entirely asset heavy.

The inflation argument on real estate is compelling too. With little warning currency devaluation could severely decrease the purchasing power of the dollar and other developed currencies. Real estate will at least retain some semblance of purchasing power. Coordinated currency devaluation in the next few years is a higher risk than portrayed.

Metals and Commodities: Like stocks, real estate and non-guaranteed debt securities - commodity prices including metals have taken it on the chin due to deleveraging by hedge funds, a stronger dollar and the prospect of slower global growth. Stocks in commodity related companies have performed worse still.

Will commodities rise up once again? Will we see global food shortages? Will future coordinated currency devaluations cause gold to become a de facto number currency? Will Asia recover and continue consuming vast energy reserves? None of us know for certain. It's equally possible that a battery engine is soon invented and 10 years from now gasoline doesn't even exist.

I consider inflation sensitive commodities to be a must have in a balanced portfolio but I'm well cognizant that commodity prices could succumb further to continued asset erosion. Buyers in this sector should start with reasonable size and with room to add on further weakness - particularly in food related groups.

Treasury Securities: As we've witnessed the past year and half not all credit markets are the same. In fact not all segments of the yield curve are the same either. Non Treasury backed issuance remains soft with default risk spread out among an array of mortgage, municipal and corporate backed securities. In general be cautious of any high yielding paper. We haven't seen the last default and municipals are going to be the next wave of collapsing securities.

While the front end (short dated paper) remains on all time low yields due to flight to quality and an ever easing Federal Reserve, the long end of the Treasury curve remains in flux. Bulls cite economic weakness and safety as the prime catalysts for lower yields, while the bear case is fear of increasing deficits, possible selling by over committed Asian central banks and the chance of severe inflationary pressure.

I suggest that if you prudently seek some diversification in the Treasury market, try to stay at an average duration of around five years. The Five year will give you an additional 100 plus basis points in yield over the two year, with much less price risk than the ten or thirty year. Don't assume that a few years from now a chart of the 30 year T-Bond can't resemble today's beleaguered financials.

Cash too is an asset: I've probably scared some of you away from any investment vehicle other than good old cash. Think again. Cash too has a risk factor we've rarely before seen. Clearly most of us sat through the pain this decade of seeing our cash reserves lose parity with a host of foreign currencies, but in the past few months many of those exchange rates have corrected in stunning fashion.

In many currencies, 5 years of dollar weakness was negated by virtually 5 weeks of dollar strength. The Australian dollar for example rose from 60 cents U.S. in early 2003 to 96 cents this past July before breaking all the way back to 62 cents late last month! As Americans we hear incessantly about our high national debt and entitlement liabilities but the rest of the world is in the same boat. Right now cash is king but the cheap assets cash can buy may someday dethrone the king. Stay agile, proactive and ready to overweight sectors only as conditions become clearer.

Kurt J. Eckhardt has been trading since 1982 when he began his career as an active floor trader in the CBOT Treasury Bond pit. Kurt is President of Eckhardt Research and Trading and its subsidiary Agility Trading. Agility offers both individuals and funds cutting edge technical strategies along with high performance instruction. For more information go to www.agilitytrading.com or email Kurt at kurt@agilitytrading.com.