Morningstar Advisor - April/May 2010 - 37

Spotlight

Be Prepared
By Philip Guziec, Paul Justice, Bradley Kay, Erik Kobayashi-Solomon, and Paul Larson

The past decade was a rocky one for investors, but the environment could prove just as rough during the next decade. True, it appears that the economy is slowly recovering from the global financial crisis and recession, but we face many big near- and long-term challenges that will affect investing. Advisors have to be ready for anything. On the following pages, we list some possible economic scenarios to keep an eye on and investing ideas to help investors tackle each situation. We are not predicting that any of these scenarios will happen, nor are we suggesting that investors substantially alter their portfolios in a bet that an event will occur. This is only a guide to help investors develop an awareness of a struggling economy’s risks and opportunities and to offer courses of action. There might come a time when tilting a portfolio in one direction or another based on economic events will make investing sense. It always pays to be prepared.

Great Recession II
How it could happen: As stimulus spending

dries up, another crisis (sovereign debt, commercial real estate, unknown) shocks a fragile recovery. Economic activity plunges again, credit tightens, unemployment rises, a huge U.S. budget deficit causes interest rates to spike and higher taxes place greater burden on consumers.
What investors can do: Buy wide-moat stocks. They held up well in Great Recession I and should do the same again. Avoid levered companies and tilt toward cash. Unconventional approach: Put a small percentage of portfolio in put options now (when implied volatilities are lower than they will be in another recession), roll the puts down as the market declines and use the proceeds to buy stocks and indexes as they decline.

will thrive no matter the environment— but especially those companies that are paying that cash to shareholders as dividends. Investments along these lines could include Vanguard High Dividend Yield VYM; utilities (Utilities Select Sector SPDR XLU, Franklin Utilities FKUTX); Altria MO; and stable, mature pipeline businesses.
Unconventional approach: Invest in a buy-write index, or write puts on cash-cow companies when their stocks get irrationally caught up in a general market decline.

Strong Economic Recovery
How it could happen: Bank lending resumes and businesses invest via capital expenditures and hiring, spurring economic activity. Employment surges and consumers regain confidence and catch up on their spending after years of forced frugality. What investors can do: Buy Vanguard Total

Stock Market VTI.
Unconventional approach: Buy stocks that benefit from expansion on the margins: for hiring, firms like Manpower MAN and Monster Worldwide MWW. Companies such as Siemens SI and GE GE would benefit from capital spending on machinery, while trucking firms and intermodal transportation firms like Pacer International PACR could also benefit. An options alternative would be to buy calls on high-beta sectors of the market levered to consumer activity.

Stagnation
How it could happen: The economy picks up

a bit as companies replenish inventories and people with jobs slowly return to spending some of their hard-earned cash. But persistent high unemployment, a weak housing market, stagnant wages, and higher inflation all hamper growth.
What investors can do: Buy wide-moat firms

and cash-cow companies with advantages that

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Morningstar Advisor - April/May 2010

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