How to Protect and Grow Your Portfolio in an Economic Downturn

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By Steve Christ

Thursday, January 24th, 2008

Well, after one day spent watching world markets get clobbered, it finally happened—Helicopter Ben earned his wings. A surprise 75-basis-point rate cut showed the markets once and for all that he finally got it.

But Ben Bernanke’s money drop notwithstanding, by all accounts—including his own—the U.S. economy is now firmly on the brink of a serious economic downturn. The business cycle, it turns out, lives after all, and a day later his rate cut has practically fallen on deaf ears.

And with the U.S. economy now seemingly staring into an economic abyss, Recession-Proof Investments are at the top of every investor’s list for 2008.

That, of course, is for a whole host of good reasons.

In fact, according to a recently released report by Merrill Lynch, the gross domestic product will expand by only 0.8 percent this year, down from an earlier forecast of 1.6 percent. Moreover, they now estimate that the U.S. economy, the world’s largest, will grow only 1 percent in 2009.

Rising unemployment, $6 trillion in lost housing wealth combined with slumping equity valuations, and the lack of participation from the baby boomers for the first time in three decades likely will result in the worst consumer recession since 1980,» the Merrill economists wrote.

That put Merrill Lynch in lockstep with both Goldman Sachs Group Inc. and Morgan Stanley as big players forecasting the U.S. will slip into recession this year.

However, even that put them all a bit behind the curve, according to the manager of the world’s biggest bond fund, PIMCO’s resident bond guru Bill Gross. He said on Tuesday that the U.S. economy probably fell into recession in December, with the housing market broadly depressing economic activity.

Housing was the big spark and now it is the consumer. weekly retail numbers are dismal, Bill Gross told Reuters.

It’s simply now a consumer-led mild recession, Gross said, that will show up in the first and second quarter GDP numbers in the negative—with a minus sign.

That, of course, is the textbook definition of a recession: two consecutive quarters of negative growth.

A Looming Recession Means More Market Pain

Now how bad it is going to be is still anybody’s guess, but if the downturn turns out to fall within the historical average, it will mean a decline in the S&P of about 20% from peak to trough.

That means that the S&P may actually need to fall to a low of 1,128 points.

Averages, though, can be tricky indeed, as the following table shows. It details the actual declines on which those averages are based. Naturally, those declines are varied.

In fact, as you can see, the real range is pretty wide, from a mild 9.02% decline in 1960 to the extreme of 43.36% in 1974. That, of course, could spell declines beyond the average based upon the depth of the downturn.

Either way, the news is hardly good for equities these days, despite the recent actions of the Fed.

1 Notable Recession Proof Investment

One way to protect your portfolio against the type of declines that took place in 70s is through an investment in Treasury Inflation Protected Securities, TIPS for short.

Like other Treasuries, these securities pay interest every six months and return the principal when the security matures. The difference is that the coupon payments and underlying principal are automatically increased to compensate for inflation as measured by the consumer price index (CPI).

That makes the win here twofold, since not only are they based in the world’s safest investment—U.S. Treasuries—but they are also hedged against inflation. So the real rate of return is guaranteed.

These securities can be purchased either directly from the U.S. Treasury or through a bank, broker or dealer through the auction process based on their yield.

As an alternative to the direct purchase route, there are also bond funds available to investors that match the performance of the TIPS themselves. Typically these high-quality funds and ETFs will invest at least 80% of their funds in inflation-protected bonds.

The upside with these funds is that their investors get the added benefit that comes from professional management. Moreover, these funds offer the liquidity that most investors need.

After all, while it may be quite easy to purchase TIPS directly, selling them is another matter entirely. Bond ETFs, naturally, make that prospect a breeze.

Here are two inflation-protected bond funds that closely match the performance of the TIPS themselves:

• Vanguard Inflation-Protected Secs (MUTF:VIPSX ). The fund invests at least 80% of assets in inflation-indexed bonds issued by the U.S. government. It may invest in bonds of any maturity, though the fund typically maintains a dollar-weighted average maturity of seven to 20 years.

• iShares Lehman TIPS Bond (ETF) (NYSE:TIP ). The fund invests at least 90% of its assets in the inflation-protected bonds and at least 95% of its assets in U.S. government bonds. It may also invest up to 10% of its assets in U.S. government bonds not included in the underlying index. Additionally, the fund invests up to 5% of its assets in repurchase agreements collateralized by U.S. government obligations and in cash and cash equivalents.

So while we stand today on the outer edges of an economic downturn that is increasingly hard to judge, an investment in TIPS may well prove to be the one recession proof investment —the lifeboat—that so many investors are desperately trying to find these days.

After all, with inflation on the rise and the worldwide markets screaming nothing but recession, the flight to safety is one that is quickly gathering steam.

And not surprisingly it’s turning where it always does—U.S. Treasuries.

Just be sure to protect yourself from the inflation that is surely headed down the pike along with all of those rate cuts.

Helicopter Ben is just warming up.

Wishing you happiness, health and wealth,

Steve Christ, Editor

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