Outlook for 2009 from RGE monitor - predicting a LONG Recession

RGE Monitor - 2009 U.S. Economic Outlook

Christian Menegatti, Arpitha Bykere, Elisa Parisi-Capone and Mikka Pineda | Jan 7, 2009

It is clear that 2008 was not a very good year and it is official that the current U.S. recession started already in December 2007. So how far are we into this recession that has already lasted longer than the previous two (1990 and 2001 recessions lasted 8 months each)? We believe the U.S. economy is only half way through a recession that will be the longest and most severe in the post war period. U.S. GDP will continue to contract throughout 2009 for a cumulative output loss of 5% and a recession that will last close to two years.

One last look at 2008 will reveal a very weak fourth quarter with GDP growth contracting -6%, in the wake of a sharp fall in personal consumption and private domestic investments. We see the real GDP growth contraction playing out through the year as follows: Q1 2009 -5%; Q2 2009 -4%; Q3 2009. -2.5%; Q4 2009 -1%, adding up to a yearly real GDP growth of -3.4% for the U.S. in 2009.

Personal Consumption

The resilient U.S. consumer started to give up in the third quarter of 2008, when for the first time in almost two decades, personal consumption contracted. With personal consumption making up over two-thirds of aggregate demand, the outlook for the U.S. consumer is at the center of the dynamics that will play out in the real economy in 2009.

In our view, personal consumption will continue to contract throughout 2009 quite sharply as a result of negative wealth effects from housing and equity market losses, the disappearance of home equity withdrawal from the second half of 2008, mounting job losses, tighter credit conditions and high debt servicing ratios (the debt to income ratio went from 70% in the 90s, to 100% in 2000 to 140% now). This retrenchment of the U.S. consumer will result in a painful rebalancing in the economy that will eventually restore the saving rate of a decade ago.

The wealth losses for households related to the fall in home prices are roughly $4 trillion so far, and are clearly bound to increase further as home prices continue to fall –eventually reaching the $6-8 trillion range (compatible with a 30-40% fall in home prices peak to trough). With a negative wealth effect of 6 cents on the dollar, the reduction in personal consumption could amount to a whopping $500bn. And negative wealth effect from fall in equity prices – on the wake of a bleak 2009 for corporate profits – will also contribute to the contraction in personal consumption by an estimated $100bn (compatible with a 25% contraction in the stock markets).

This adjustment is consistent with a rebalancing of the economy that will over time bring the saving rate to a positive level of roughly 5-6% where it was a decade ago, for this to happen consumption has to contract by an amount close to $800bn.

Housing Sector


The 4th year of housing recession is well on course.

Total housing starts have plunged from the 2.3 million seasonally adjusted annual rate (SAAR) peak of January 2006 all the way to the 625 thousand SAAR of November 2008 (the last data point available), an all time low for the time series that started in January 1959. Single-family starts built for sale are down 75% from their Q4 2005 peak (seasonally adjusted data are not available, we performed our own seasonal adjustment).

On the demand side, new single-family home sales are down 65% from their July 2005 peak. Both demand and supply of homes are therefore still falling very sharply which does not bode well for inventories. Inventories are the mortal enemy of prices for any goods-producing sector, including housing.

Starts need to fall substantially below sales so that the excess supply in the housing market is reabsorbed. Inventories persist at record highs and the gap between one-family starts (for sale) and one-family sales (-92K annual rate in Q3 2008 according to our estimates) is at levels that cannot promote a fast work–off of inventories. To put these numbers in perspective, compare this with a measure of vacant homes for-sale-only. Vacant homes for-sale-only were at 2.2 million in Q3 2008, an all time high. In the decade between 1985 and 1995 it oscillated around 1 million units on average and 1.3 million units between 2001 and 2005. This implies that we have to deal with an excess supply that ranges between 0.9 and 1.2 million units, of which roughly 85% are single-family structures.

The sharp and unprecedented fall of starts might not have reached a bottom yet. In this economy-wide recession, weakness on the demand side is bound to persist and we believe that supply will have to fall further, given also the great wave of foreclosures that is adding to the excess of supply in the market. We see starts falling another 20% from current levels.

We believe that home prices will not bottom out until the middle of 2010. Our target is a 38% peak to trough (so far prices have fallen 25% from the peak) but given the worsening conditions on the real side of the economy, we see a meaningful chance for over-correction that would bring prices down 44% from the peak reached in the first half of 2006 (Case-Shiller is the reference index for these predictions.)

Labor Markets

With continued credit crunch and significant cut down in consumer and business spending, the monthly job losses will continue in the 400-500k and 300-400k range during the first two quarters of 2009 respectively, bringing the unemployment rate to 8% by mid-2009. The severe contraction in private demand until early 2010 will keep lay-offs high and the unemployment rate elevated over 8%.

Economy wide job cuts are expected, with big corporations and small enterprises, residential and commercial construction, financial services and manufacturing continuing to shed jobs at a strong pace. Moreover with structural shifts in the economy since the last recession, job losses this time will be more severe in the service sector, including retail, business and professional services and leisure and hospitality. Unless the fiscal stimulus addresses the deficit problem for state and local government, job losses at the government level will also gain pace. In turn, income and job losses will further push up default and delinquency rates on mortgages, consumer loans and credit cards. Moreover, the loss of high paying corporate and financial sector jobs will be a big negative for tax revenues over the next two years.

Lay-offs are bound to continue thereafter as cost-cutting gains pace with the beginning of the (sluggish) recovery period in early 2010. Even as consumer demand might show some signs of recovery, firms, like in the past, will begin by hiring only part-time and temporary workers initially. The unemployment rate might peak at close to 9% in Q1 2010, almost two years after the recession began. However, the hiring freeze across industries that began in late 2007 will continue at least until 2010 causing discouraged workers to leave the work force and containing the extent of the spike in the unemployment rate. Further, the decline in labor utilization will add to the deflationary pressure in the economy. An aging labor force, lower capital spending and potential growth over the next few years might also result in lower productivity growth and an increase in the natural rate of unemployment (NAIRU).

Capital Expenditure

Firms have been drawing down inventories beginning in Q4 2008. As the slump in domestic and foreign demand and difficulty in accessing short-term credit persist over the next four quarters, business investment is bound to contract in double-digits throughout 2009. Industrial production, spending on equipment and durable goods will also remain in red through 2009. Moreover with a sluggish recovery in private demand even during 2010, firms will start building inventories and contemplate capex plans only at a slower pace.

Trade

Exports contraction that began in late 2008 will gain pace in 2009 as more and more emerging economies slip into slowdown following the G-7 countries. On the other hand, easing oil prices and secular downward trend in consumer spending and business investment will help imports to shrink. In fact, this might cause the trade deficit to contract in 1H 2009 since the contraction in imports might well exceed the decline in exports, thus containing any negative contribution of trade to GDP growth.

Dollar Outlook

The fate of the U.S. dollar in 2009 rests on the global growth outlook. After profit-taking on long USD positions ends and trading volumes pick up as investors return from their holidays, the dollar may temporarily recover its relative safe haven status in H1 2009. Since markets have yet to fully appreciate the impact of the commodity slump and financial crisis on the rest of the world, risk appetite may collapse again on signs of a deeper- or longer-than-expected recession outside the U.S.. Further de-leveraging of USD-denominated liabilities could provide an additional boost to the dollar as a funding currency. The bond yield outlook could be a further source of strength: while the Fed is already at ZIRP, other central banks will cut rates further to stimulate growth, putting downward pressure on currencies like the Euro. Alternating with these upside risks to the dollar may be downside risks from 1) a supply crunch in commodities that lifts commodity prices and producers' economies, 2) inability of the market to absorb increased Treasury supply at low yields.

Downside risks to the dollar seem more likely to outweigh upside risks in the latter half of 2009 and in 2010. Yet at the same time, similar downside risks exist for other currencies – growing fiscal deficits will weaken a range of currencies. With emerging markets continuing to have trouble attracting capital and Asian economies, hammered by export contractions, will be reluctant to allow their currencies to appreciate against or with the dollar – China allowed some depreciation of the RMB at the recent euro-dollar peak.

Once crucial support from deleveraging wanes, however, the dollar may be left with only foreign central bank reserve accumulation, which has already waned on the reversal of capital flows, to finance the large U.S. current account deficit. Continued repatriation of assets and higher enforced domestic savings rates will at least reduce pressure on the dollar in the short-term.

Inflation/Deflation



Annual U.S. inflation, as measured by official producer and consumer price indices, is likely to slow in 2009 and even fall into technical deflation despite increases in the monetary base and fiscal measures to boost spending power. Slumping commodity prices may drag down the average annual headline CPI inflation rate to around -2% - a technical deflation which may morph into genuine deflation if falling prices generate expectations that they will continue to fall. Meanwhile, the growing slack in product and labor markets will keep core consumer inflation subdued at an average year-over-year rate of 1-2%. Steep discounts to get rid of unsold retail inventory, rising job losses and lower wage growth will reinforce the trend of stagnant or falling prices. Loose labor markets and weak demand for commodities and goods/services will keep producer prices at bay. Risks to the outlook include 1) a commodity supply crunch or geopolitical shock that leads to a sustained rise in commodity prices and 2) an earlier than expected global economic recovery.

Credit Losses Still Ahead



Back in February 2008, Nouriel Roubini warned that that the credit losses of this financial crisis would amount to at least $1 trillion and most likely closer to $2 trillion. As of mid-November 2008, the threshold of $1 trillion in global financial writedowns was finally reached. Given that national house prices expected to drop another 20%, we expect credit losses of $1.6 trillion.

An in-depth analysis of current and expected loan losses per asset class and separately of mark-to-market writedowns per securities class based on current prices indeed confirms RGE’s initial loss range estimates (outstanding loan and securities amounts as in IMF GFSR, Table 1.1) For our calculations we assume a further 20% fall in house prices, and an unemployment rate of 9%. With respect to credit losses on unsecuritized loans, recent research by the Fed Board using comparable assumptions (but assuming high oil prices) concludes that over half of 2006-2007 subprime mortgage originations are going to default (i.e. $150bn out of $300bn). The loss trajectories for Alt-A loans are similar resulting in a 25% default rate ($150bn out of $600bn). Even prime mortgage delinquencies display a very high correlation with subprime loan delinquencies, implying an approximate 7% default rate when the potential for ‘jingle mail’ is taken into account ($266bn out of $3,800bn).

The cycle has also turned in the commercial real estate (CRE) arena with the traditional lag of around 2 years. Current serious delinquency plus default rates of 5.9% of CRE loans (net recovery, via Fed data) are projected to increase to up to 17% by Fitch assuming a 25% fall in prices ($408bn out of $2.4 trillion.) In the consumer loan area, we estimate credit card charge-off rate could increase to 13% in the worst case scenario. Adding a typical 5% delinquency rate during recessions, the total loan losses on unsecuritized consumer loans are projected to increase to $252bn out of $1.4 trillion (see The U.S. Credit Card Industry in 2009, by RGE’s Mathias Kruettli.)

The IMF warned that commercial and industrial loans (C&I) charge-off and delinquency rates are likely to climb to historical peaks and potentially beyond in this cycle. Compared to past C&I loan loss rates, we project charge-off and serious delinquencies to reach 10% or $370bn out of $3.7 trillion of unsecuritized C&I loans. With regard to leveraged loans, the latest research by Boston Consulting/IESE Business School based on the 100 largest PE firms engaged in LBOs calculates an expected book loss from default of about 30%. This translates into $51bn out of $170bn unsecuritized leverage loans.

Based on these calculations, RGE expects total loan losses to reach about $1.6 trillion out of $12.4 trillion of unsecuritized loans alone, implying an aggregate default rate of over 13%. The IMF assumes that the U.S. banking system carries about 60-70% of unsecuritized loan losses (and about 30% of mark-to-market losses on securitizations). Even assuming that future loan losses are fully discounted at current market prices, deploying the remaining TARP funds towards recapitalizing the banking system would still be warranted.

The Disconnect Between Bond and Equity Markets



U.S. government bonds were on a tear in 2008, while equities plummeted in a nasty bear market. Bond yields at the long end hit all-time record lows, while the short end even dipped into negative territory. Only TIPS suffered as deflation risks rose. Stocks, on the other hand, had their worst year since the Great Depressions: DJIA lost 34%, S&P 500 -38.5%. At its 2008 low on November 20, the S&P 500 was down 49% for the year and 52% from its October 2007 peak. Stocks rallied in December though, resulting in an apparent disagreement between the stock and bond markets over the outlook for the U.S. economy. Bond markets seemed to be discounting a recession in 2009 while stock markets have been gaining since late November. This disconnect may vanish in 2009 though if the stock market rally was really just a bear market rally due to portfolio re-balancing and thin year-end trade volumes.

However, there have been intimations that the bond market is in a bubble about to burst in 2009. Indeed, with ultra low bond yields, investors may be tempted to switch into higher-yielding equities - which are now considered by many to be undervalued. Valuation, however, is not the be-all and end-all of asset performance. The credit freeze needs to end before equities can see the end of the bear market. However, considering the likely economic stagnation ahead, bonds should be a better bet than equities for some time. We see meaningful downside risks to stock prices as bad macro news – worse than expected – continues to dominate in 2009. Using the S&P 500 as benchmark, earnings per share will stay in the $50-60 range – and earnings will fall further. If, and it is not unusual during recessions, P/E ratio falls in the 12-14 range, we could see another 25% slide in stock prices.

Fiscal and Monetary Policy

Fiscal Policy

A lot of hope is being placed on the expected fiscal stimulus package of around $750 bn spread over 2009-10 including 40% of the stimulus in tax cuts for households and firms. Around half of the stimulus is expected to kick-in starting Q2 2009 and through 2010. But this will fall short of the pull-back in private demand of close to $1 trillion during this period.

Infrastructure spending, in spite of being highly effective, might not be timely, stimulating the economy only in late-2009 and 2010 when it has well passed the severe recession phase only to exacerbate the ballooning fiscal deficit. Nonetheless, around $100bn of infrastructure investment might be able to kick-in during 2009. Moreover, job creation in infrastructure might be overestimated given limitations in moving laid-off workers from other sectors to the infrastructure projects. As such, any job creation via government spending and tax incentives for firms will significantly fall short of the ongoing lay-offs.

Given the drawback of the ‘spending’ component of the stimulus, the government may be enticed to implement more tax cuts. While tax incentives for households like payroll and child tax credit might be well-targeted at the group with high propensity to spend, tax cuts in general will be less effective in stimulating demand given a secular rise in the saving rate expected over the next few years. Likewise, tax breaks for firms hiring new workers or investing in new equipment will be rather ineffective since businesses see little viability in doing so during a slump in domestic and export demand. At the most, tax stimulus in spite of being timely and well-targeted will cause only a temporary rebound in the economy for a month or a quarter merely shifting the spending decision period just like tax rebates did in 2Q 2008.

Expansion of unemployment benefits, food stamps and other incentives will have a high bang-for-buck effect in 2009 and will only assuage the impact of the recession. The stimulus will also include up to $100 bn for state and local governments to meet their severe budget shortfalls including grants, Medicaid and unemployment insurance funds, preventing cutbacks in public services, investment and jobs in several recession-hit states. But again, fiscal aid for states often suffers from time lags.

Fiscal stimulus, TARP spending, GSEs-related expenditure along with further slowdown in corporate and individual income tax revenues will push the fiscal deficit to around $1.3 trillion in FY2009.

Monetary Policy

The Fed has enacted a wide and unprecedented range of measures to mitigate the credit crisis and stimulate the economy. It has already cut its target range for the Fed funds rate down to 0-0.25% (essentially ZIRP) but, more importantly, it has created currency swap lines and an alphabet soup of programs to provide liquidity to the financial system and clean out toxic financial assets. The Fed experimented with different forms of financing itself in order to enable a sharp expansion of its balance sheet to accommodate these liquidity facilities. In addition to rate cuts and quantitative easing, the Fed has directly aided failing financial institutions. Now, the Fed is considering issuing its own debt and/or purchasing long-dated Treasuries and Agency debt. Will the monetary easing work? So far, the increase in money supply has not been accompanied by an increase in the velocity of money. In other words, credit growth remains stagnant as banks are reluctant to lend back out the money provided by the Fed and, at the same time, borrower demand has fallen.

Sectors to Short (from Morningstar)

Stock Strategist


Four Sectors to Avoid, Sell, or Short with ETFs
By Paul Justice, CFA | 11-21-08 | 12:00 PM

Unless you've been on the sidelines or have been shorting the market since the summer, chances are that you have more than a few double-digit losers in your portfolio. You are not alone. I have my fair share of losers, and so do most of yesteryear's "top" money managers. Now, we could all get together and have a big kumbaya party, but that would simply treat the symptoms while ignoring the disease. We would be better served by taking our feelings out of the equation, reviewing our investment strategy, reassessing our tactical investment decisions, and learning from any mistakes that we've made. Once the errors have been identified, rectify them by either determining whether they merit staying in your portfolio or by selling them regardless of how much they have lost.


An interesting bit from the annals of behavioral finance theory is Kahneman and Tversky's prospect theory, which suggests that individuals are more upset by losses than they are pleased by equivalent gains. The pain is so great that investors in stocks avoid selling losers and often take even greater risks in the hope of simply breaking even. The same research also suggests that investors avoid making short sales (bets that an investment will go down) simply because they are afraid of having to cover their short positions at a loss sometime down the road.

Admittedly, short-selling is not for everyone. Don't do it without a sound thesis, considerable research, and a tough stomach. Over the long haul, stocks tend to go up (at least the past says so--let's hope that is still true). But no investor should avoid selling an investment that is down 50% simply in the hope that it will rebound. Here's a fact: An investment that fell 50% from where you purchased it can still go down 100% from where it is today. Reallocating those funds to a better prospect is a good idea, especially if you can use those realized losses to offset taxable gains.

With selling in mind, we've outlined five ETFs that investors should consider selling today. Where appropriate, we've tried to give investors a viable alternative to either purchase outright or with which to establish a pair trade.

High-Yield Corporate Bonds

In September and October, the credit spreads on high-yield bonds shot to never-before-seen levels. As of this writing, the high-water mark was roughly somewhere around 1,550 basis points over Treasury bonds, which translates to yields of nearly 20%. Still, we recommend that investors avoid high-yield ETFs such as iShares iBoxx $ High Yield Corporate Bond (HYG) and SPDR Lehman High Yield Bond (JNK) for the simple reason that we think things are going to get worse for high-yield issuers before they get better. Loose lending was not limited to residential mortgages during the past five years. Buyout firms and companies drank their fill from the cheap and easy debt trough. Now we have a host of companies that were overleveraged during the best of economic times staring a prolonged recession in the face. When a company has a weak balance sheet, its borrowing costs are rising, and its profits are dropping, the likelihood of bankruptcy increases exponentially. Many forecasters are projecting the default rates on these bonds will rise to anywhere between 8% and 12%. We fear that number could go much higher as the shutdown in the capital markets will preclude these firms from selling assets, raising equity, or even rolling over existing debt, thus exacerbating the impact of an economic recession.

Investors looking to capitalize on the high credit spreads that exist throughout the market would be much better served considering an investment in investment grade corporate bonds like those represented by iShares iBoxx $ Investment Grade Corporate Bond (LQD). Even this is not without risk, given that both Lehman and Washington Mutual were still rated investment grade when they went under. Still, the diversification of risk offered by the index structure will minimize the impact of one-off collapses keeping investors from suffering the permanent capital impairment that would have come from holding just a single bond issue.


Emerging Market Large-Caps
Large-cap emerging-markets equities are facing a Category 5 storm of bad market conditions. The global recession continues to drive down commodity prices, which will decimate the earnings of companies like Petrobras (PZE), Gazprom, and Posco (PKX)). National champion banks such as HDFC (HDB), China Construction Bank, and Banco Santander-Chile lent the billions of dollars of credit that funded the recent boom, and their future now holds higher default rates, few profitable loan opportunities, and even the possibility of governments forcing new credit to be supplied at artificially low rates. The advanced technology conglomerates like Samsung and Taiwan Semiconductor (TSM) face the worst global environment for consumer discretionary spending in decades. Finally, emerging-markets currencies are plummeting against the dollar, which further exacerbates the losses for U.S. shareholders. The most positive thing we can say about emerging-markets large caps is that they have already been beaten up, having dropped nearly 60% for the year to date, but that hardly precludes further losses given the potential for currency crises and the still-forthcoming bad earnings news from banks and commodities producers. Investors with stakes in iShares MSCI Emerging Markets Index (EEM) or BLDRs Emerging Markets 50 ADR Index (ADRE) should consider selling out or even shorting.

A naked bet on further falls may seem too risky. After all, the MSCI Emerging Markets Index trades around a P/E ratio of 8.5 and a price/cash flow ratio of 5.5. Clearly these stock prices already anticipate a deep recession and poor future earnings, so how much further could they fall? To offset the potential risk that emerging markets have hit bottom, we suggest a long position in emerging-markets small caps using WisdomTree Emerging Markets SmallCap Dividend (DGS). Relative to emerging-markets large caps, this fund has far less exposure to commodities producers or telecoms while concentrating instead in local consumer and business services, which should hold up relatively well as growth in emerging economies merely slows rather than halting. WisdomTree Emerging Markets SmallCap also has far smaller investments in the vulnerable Chinese, Mexican, Indian, and Russian markets than its rival large-cap funds, which should help its relative performance. Finally, emerging-markets small caps are likely to outperform because they will start from an even cheaper basis. Although these stocks did not fully participate in the gigantic emerging-markets rally of 2003-07, they have suffered alongside large caps in the fall. For that reason and the general value tilt from WisdomTree's dividend-weighting methodology, the stocks in WisdomTree Emerging Markets SmallCap Dividend are currently trading at a P/E ratio of 7 and a stunningly low price/cash flow ratio of 4.7 despite their brighter future! Shorting emerging-markets large caps and investing in their smaller cousins provides a tempting relative-value trade for intrepid investors.


Coal Producers
Few sectors were impacted as greatly as the energy sector by the proliferation of new ETFs over the past two years. Nuclear, natural gas, oil, and alternative energy all have several different funds from which to choose, and most of those include inverse and leveraged bets for both long investments and shorting. Included in that lineup was Market Vectors Coal ETF (KOL), an ETF frequently purchased by individual investors in the face of rising coal prices. What many investors failed to consider when spot coal prices were soaring is the fact that over 90% of the trading of this commodity is conducted via direct contracts. Thus, the spot market is only a proxy for a small fraction of the actual sales. Not all coal producers were realizing triple-digit prices for their goods, and those that were have seen the spot market evaporate with the recent pullback in global economic activity. While our equity analysts see only a modest contraction in the volume of coal consumed for electricity production over the next few years, the same cannot be said for coal used by industrial consumers. Thus, the good times for coal producers will not likely reach the levels seen in 2007 and 2008 until robust world economic growth returns. Throw in the sweeping victory by Democrats, and the appointment of Henry Waxman as chairman of the Energy and Commerce Committee replacing John Dingell, and it appears the federal government's attitude toward curbing greenhouse gas emissions is becoming more determined. Given coal's distinct disadvantage in this space, times indeed look more pessimistic for America's most abundant fuel.


REITs
The residential real estate market sits at the epicenter of the current crisis. Chances are that if you've picked up a newspaper or turned on the television over the past few months then you've already been briefed on just how ugly it's getting out there. However, we'd also like to highlight some cracks we see in the commercial real estate market. We want to caution investors about a potential parade of dividend cuts that seem to be on the horizon for the REIT industry. Avoiding the sector altogether is probably a wise choice, but the most daring and risk-seeking investors might even consider selling the sector short.

The REIT market has benefited over the past several years from loose credit terms, low interest rates, and rising property values. Strong and consistent historical performances over this period led many investors to believe that REITs could be considered a safe haven with healthy dividend income streams. Surprise! The party is now over. The tail winds that benefited the industry over the past several years are turning into strong head winds. Many firms in the industry took on unsustainable levels of debt to expand their asset bases. Now, those same assets are falling precipitously in value. We should also expect to see rental rates come down as vacancy rates increase. This should in turn depress cash flows and possibly impair some firms' ability to meet the debt obligations they assumed when the economic outlook was rosy. The long lead times that are typical for commercial real estate projects brings up another issue. Many projects that were undertaken a few years ago may have been economically attractive at the time. However, things have changed drastically and many projects may turn out to be value destroyers. But, because many projects are already so close to completion, there's no turning back.

So, how can investors apply this sector thesis? UltraShort Real Estate ProShares (SRS
SRS) is the easiest way to gain leveraged short exposure to the industry. Barclays' iShares family of ETFs has also sliced the REIT market every which way, so we'd take a look at getting short the retail and hotel subsectors of the REIT industry there (iShares FTSE NAREIT Retail (RTL) and iShares FTSE NAREIT Industrial/Office (FIO)). The most popular REIT ETFs, in terms of assets under management, that investors may wish to keep an eye on include Vanguard REIT Index ETF (VNQ), iShares Dow Jones US Real Estate (IYR), and SPDR DJ Wilshire REIT (RWR).
John Gabriel









Paul Justice is a senior stock analyst with Morningstar.

Make Money in Down Markets - an easy and simple way to hedge

Hedge Your Portfolio
from US News and World Report

By Katy Marquardt
Posted December 20, 2007

It can pay to play defense in a market often buffeted by fast and furious one-day drops. In small doses, funds that use hedging strategies can reduce risk in your overall portfolio because their performance doesn't move in tandem with the stock or bond markets. Using sophisticated techniques such as short-selling and options, these funds aim to guard against market declines and still produce respectable long-term returns.



When former economics professor John Hussman's market outlook is gloomy, he can hedge some—or all—of his Hussman Strategic Growth fund using options to bet against major market indexes. The fund is currently fully hedged, its most bearish position. The portfolio holds more than 100 stocks Hussman thinks are somewhat cheap relative to their growth potential. "We're also hedged with indexes that behave similarly and reflect the stocks we own," says Hussman. "The idea is to earn the difference in the stocks' performance." The fund, which returned 11 percent a year on average from its July 2000 launch through December 1, charges a below-average 1.17 percent in annual expenses.

Michael Orkin hedges his Caldwell & Orkin Market Opportunity fund by short-selling—or betting against—individual stocks or sectors. Orkin's bets against the home-building and subprime mortgage sectors helped the fund gain a whopping 33 percent over the past year. It returned an annualized 7 percent over the past decade, 1 percentage point ahead of the S&P 500, with significantly less volatility. The fund charges 1.75 percent in annual fees.

You can execute your own hedging strategy by investing in an exchange-traded fund (ETF) that bets on the decline of an index, investing style, or sector of the market. ProShares' short-selling etfs produce inverse returns of a particular index. For instance, the Short Dow30 bets against the Dow Jones industrial average. The firm also offers a line of "ultra" funds, which essentially return double the opposite of an index's daily gain. Although these funds aren't as risky as pure short-selling, approach them with caution.


http://www.usnews.com/articles/news/50-ways-to-improve-your-life/2007/12/20/hedge-your-portfolio.html