May 25, 2013 Rolling In The Deep

Risk/Reward Vol 171

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

"I can see clearly now/The rain is gone
I can see all obstacles/In my way
I think I can make it now/The pain is gone
All of the bad feelings have disappeared."---lyrics from "I Can See Clearly Now" sung by Johnny Nash

"This is the end
Hold your breath/And count to ten
Feel the earth/And then
Hear my heart burst again."---lyrics from "Skyfall" sung by Adele

"Live a simple life/In a quiet town
Steady as she goes/Steady as she goes."---lyrics from "Steady as She Goes" sung by Adele

Thanks to conflicting reports from the Federal Reserve, "I can see clearly now" what likely will happen once the Fed actually decides to taper quantitative easing. Wednesday morning, Fed Chair Ben Bernanke testified that it was too early to consider any tapering of the $85billion monthly asset purchase program known as QE3. Proving that the current market rally is driven largely by the Fed's monetary policy (read, QE3), the Dow Jones Industrial Average (DJIA) soared 151 points on Bernanke's confirmatory remarks. Later in the day, however, minutes of a Fed meeting held earlier this month were released. Those minutes indicated that some Fed members were in favor of tapering sooner than indicated by the Chair, even as early as June. On that news, the DJIA quickly plunged 258 points, ending down 80 points (0.6%) for the day. On Thursday, that drop in the DJIA coupled with disappointing news from China caused the Japanese market to crater 7%--- in just one day! Back home, Thursday traded down and Friday closed flat. Ouch, those three days hurt! But with the weekend upon us, "the pain is gone" and even "the rain is gone" (which is a miracle here in Michigan). "The bad feelings have disappeared." Indeed, with the weekend's calm has come some valuable insight.

Wednesday was an omen. Once the Fed signals that "This is the end" of QE3, the "Sky (will) fall" on any leveraged investment; that is, any investment that is highly dependent on QE3-induced inexpensive debt for profits. One need not "hold your breath and count to ten" to presage this. Indeed, I have known it all along. But nothing could serve as a better reminder than the dropkick I received on Wednesday. In my portfolio, the holdings most dependent on a continuation of inexpensive debt (and thus the ones most at risk come "the end" of QE3) are real estate investment trusts (particularly mortgage REITs), business development companies and leveraged closed end funds. Stocks that held their own on Wednesday were unlevered dividend plays like PGX and PGF and those stocks hedged against interest rate increases like floating rate loan funds. Oil was a mixed bag, although my recent purchase of GSTpA (thanks to loyal reader, WCJ) did very well in the storm.

If I don't want to " hear my heart burst again", how do I position the portfolio for the end of QE3? First, I find stocks that were "steady as she goes" during Wednesday's crash. And second, I acknowledge that the marginal gain available via leveraged investments is not worth the risk. If that translates into a portfolio that yields dividends that are 100-200 basis points (100 basis points =1%) lower than my current average, so be it. Year to date, I have profited sufficiently from principle appreciation to compensate for the difference. I can afford a "simple life in a quiet town" at least through 2013. Over the next few days, I will sell the leveraged positions on upticks and redeploy the proceeds into "steadier" fare.

And so the week ends with a lesson re-learned: because I hold a large number of leveraged assets my declines were greater than those of the broader market. This is not acceptable to me, Adele. I don't need to go "Rolling in the Deep" risk pool. "Rumor Has It" that is where I have been.