Investing: Surviving the Wall Street Quake

Listen up: Here's how the big shakeup could affect your portfolioand what you can do to protect it

If you're an investor who woke up on the morning of Sept. 15 to a new level of alarm in the more than year-old financial crisis and wondered what the drastically changed landscape on Wall Street means for your portfolio, you're not alone.

Lehman Brothers Holdings' (LEH) massive bankruptcy filing, the possibility that insurance giant American International Group (AIG) could succumb by the end of this week, and the prospective disappearance of Merrill Lynch (MER) via a merger with Bank of America (BAC) sent the market reeling with fear at the potential for huge losses to investment portfolios.

While the damage that Lehman Brothers' filing for Chapter 11 protection could inflict on investors is anyone's guess for the moment, it's sure to extend beyond the shares of the investment bank owned by mutual funds to contracts that banking counterparties had with Lehman. An AIG failure. if it materializes, would be much more devastating, in view of "the huge spectrum of investors" who own the stock or the still highly rated corporate debt or have other kinds of exposure to the company, such as insurance policies, says Bill Larkin, a portfolio manager for fixed income at Cabot Money Management in Salem, Mass.

New York Steps In

"If you have a guaranteed annuity by AIG, what does that mean today? Those are people that the government doesn't want to get hurt," he says. His worry was that if the shares closed below $5 on Sept. 15, it would accelerate ratings downgrades and invite predatory buyout offers from entities that would force the company to dispose of assets that generate the most revenue.

AIG's stock finished nearly 61% lower, at $4.76, on Sept. 15 despite news that New York state will allow AIG to borrow up to $20 billion from its subsidiaries and a Wall Street Journal report that the U.S. government has asked Goldman Sachs (GS) and JPMorgan Chase (JPM) to head up a lending facility for AIG worth $70 billion to $75 billion.

Nearly as big a fear is that even if the company survives, its cost of borrowing could rise to such an extent that it would no longer be able to turn a profit from some of its businesses. "People have been trying to get out of their corporate bonds in AIG for the last month," which has caused yield spreads vs. risk-free Treasuries to widen to extremes, says Larkin. AIG's double-A rated 5.85% coupon notes due Jan. 16, 2018 had a yield of just over 14% on Sept. 15, vs. the 9.1% yield on the double-B rated Merrill Lynch high-yield index, he says.

Debt Pulled from Networks

Larkin thinks prices for AIG's senior debt probably haven't been hammered that much because the company has so many valuable assets that could be sold to pay off debt holders. Still, on Sept. 15, the widening yield spreads prompted certain broker networks to pull all the AIG debt from electronic trading platforms because they didn't want anyone to get stuck with orders they couldn't fill.

Anyone tempted to do some bottom-picking in the financial sector would do better to buy a retail bank index rather than any one individual stock, says Larkin. Given the interconnecting Web of obligations in the banking industry, it's hard to know which banks have counterparty risk exposure to Lehman and whether their debt will be made whole at the end of the Lehman's bankruptcy process, he says.

Those who believe there's much more pain ahead for the financial industry could take short positions in stocks of financial companies, as Lou Stanasolovich, chief executive of Legend Financial Advisors in Pittsburgh, says he did on Sept. 15. He increased his holdings in the UltraShort Financials ProShares (SKF), an exchange-traded fund that is inversely correlated to moves in financial stocks so that for every dollar that financial stocks fall the ProShares ETF gains two dollars, and vice versa.

Fleeing Financial Stocks

Stanasolovich also thinks consumer staples stocks could be winners in the near term as people flee financials and commodity-based stocks.

The panic this unprecedented series of events has induced is unnecessary if investors can gain some perspective on the losses they have suffered, says Ken Kamen, president of Mercadien Asset Management in Hamilton, N.J. First, investors need to break down the losses in the fixed-income, cash, and equities portions of their portfolios. For example, if their equity positions are down 10%, that's only half as much as the broader equity market, which should offer some consolation that their assets are well diversified. On the other hand, if someone's overall portfolio has lost 30% to 40% of its value, it suggests their wealth was overly concentrated in equities, he says.

Investors whose portfolios haven't lost that much relative to the broader market should be able to sleep comfortably, says Kamen. If you're not sure what the market turmoil means for your portfolio, that should be a red flag that you aren't as engaged in your investing decisions as you need to be, he adds.

Preserving Capital is Key

No matter how your portfolio compares to others, for conservative investors the priority should be capital preservation, says Cabot's Larkin. People have to decide when they should cut their losses and exit positions instead of riding stocks down to ridiculously low levels. "If you're risk-averse, you want to be careful about what you're holding right now." After the Sept. 7 announcement that Fannie [Mae] and Freddie [Mac] were being placed under conservatorship, declines in the their preferred shares "took the whole preferred market with them," he says.

While Stanoslovich at Legend says he's not sure if any asset class can be regarded as a safe haven these days, he suggests sticking with high-quality fixed-income assets such as Treasury bonds and also recommends high-yield currency plays like the Japanese yen and the Swiss franc, which are safest to own through ETFs such as those that Rydex Investments offers. Both currencies are bets on flagging confidence in the dollar—and, by extension, in the U.S. economy—while the the yen usually gains value when U.S. stocks are in the doldrums, he notes.

Kamen says he typically advises clients to keep six months' worth of cash on hand so they won't need to sell equities when their prices are depressed, but in the current environment it may be better to have nine months to a year's worth of cash available because you don't know when the market will rebound.

Eyeing Alternative Investments

One of the safest ways to hold cash "if you're looking for guarantees and willing to suffer very low returns" is through bank deposit notes. A five-year CD might pay as much as 5% interest, compared with the 3% yield on five-year Treasury bonds, says Jeffrey Camarda, chief executive of Camarda Financial Advisors, in Fleming Island, Fla.

David Joy, chief market strategist at RiverSource Investments in Minneapolis. says he's opted more for alternative investments such as currency ETFs than holding more cash as a way to diversify his clients' portfolios. He says he's boosted his exposure to currencies through his firms's own Absolute Return Currency Fund, a quantitative strategy that takes long positions on some currencies and shorts others. The strategy has virtually no correlation to U.S. stocks, he says.

Joy thinks energy stocks such as oil producers—and especially oilfield service and equipment providers—are a good place to invest after the correction in those sectors. The same thought process applies to emerging markets, with the MSCI Emerging Markets Index down 30% in the past year, he adds,

Lots of Good Buys

Most investors should be thinking of the tumultuous events in the financial industry in terms of creating a long-term opportunity, says Joy. "There's a lot of what had been excessively high valuations that are now back to where they probably represent good value for long-term investors," he said.

It's impossible to know whether equity markets have corrected to the point where it's safe to start putting money back into them, but for people with patience and more than a two-year investment horizon, there are some good buys that are hard to pass up, he says.

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