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ETF Strategies to Profit During Times of Stagflation

ETF Strategies to Profit During Times of Stagflation

These are the times that try men's souls. -- Thomas Paine

Tom Paine should have been a financial advisor. Attempting to bolster the spirits of Continentals after a retreat from a superior British force in the winter of 1776, Paine wrote, “The harder the conflict, the more glorious the triumph. What we obtain too cheap, we esteem too lightly.”

So it goes with investments.

Given the recent string of 400-plus Dow point days, the equity market is gyrating now in ways not seen before, unnerving clients (well, some of them). Many investors now want to retreat from equities much like the summer soldiers and sunshine patriots of the Revolutionary War shrank from battle in the winter of 1776.

Clients look to their advisors for advice and now’s the time to offer it.

What should that advice be? Simply this: If properly allocated, stay the course; if not properly allocated, become so. Advisors need to be heard as the voice of reason over the din of market panic.

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First of all, put the current crisis into perspective. True, it’s a volatile marketplace. Despite appearances, though, this isn’t record volatility - at least as measured by the CBOE Volatility Index, or VIX. Keep in mind that the VIX screamed to an all-time high of 172.79 during the October 1987 market crash. VIX was clocked at 89.53 in the 2008 market swoon. And the high water mark for the current crisis? A 48.00 reading notched on August 8. Though the VIX spiked to double its recent average, there’s by no means the degree of fear gripping the market now as there was in 1987 and 2008.

Benjamin Graham, observing the irrationality that seized the market in the Great Depression, observed, “The investor's chief problem - and even his worst enemy - is likely to be himself.”
Graham recognized that solo investing requires a certain mentality, “Individuals who cannot master their emotions,” he said, “are ill-suited to profit from the investment process.”

Advisors earn their stripes by keeping their clients focused on their investment objectives. Now, one client’s proper allocation may not look exactly like another’s, but there are some essential exposures that are appropriate for most portfolios. The objective of a proper allocation is minimization of the need, and cost, of constant tweaking. A good portfolio should hold a relatively keel in market tempests, dampening volatility and the risk of capital drawdowns.

Granted, there’s not a lot of sunshine on the near-term economic horizon. These are plainly not “go-go” times. Still, U.S. corporate earnings are solid and bond auctions are well bid. Overall, economic growth is sluggish, but at least it’s positive. What we’ve got now is a 1970s-style stagflation.

So, what kind of allocations should be included in a portfolio premised on slow growth and inflation?

The relatively low reward potential for common stock makes dividend-payers particularly attractive for domestic equity allocations. Layers of utilities and preferred shares can be quickly and cheaply added with exchange-traded funds (ETFs). No dealer agreements are needed and the assets are completely portable.

The Utilities Select SPDR (NYSE Arca: XLU), the largest of the utilities ETFs, pays out a 4 percent dividend yield which, combined with its capital appreciation, produced a total return of 13.9 percent over the past 12 months.

A 2.3 percent dividend yield has spun off the iShares S&P U.S. Preferred Stock Index Fund (NYSE Arca: PFF) over the past year, contributing to the ETF’s 5.6 percent total return.

If dividend-paying equities can enhance a domestic stock allocation, there’s no reason they couldn’t do the same for investors’ international exposure. The WisdomTree Emerging Markets Income Fund (NYSE Arca: DEM) cranks out a 3.5 percent current yield and snagged a 20.6 percent total return over the last 12 months.

On the fixed-income side, an allocation to the iShares Barclays Capital TIPS Bond Fund (NYSE Arca: TIP) can provide a hedge against incipient inflation together with a 3.9 percent current yield. All in, the ETF gained 11.8 percent in the past year.

The commodities sector is another inflation hedge. Most commodity sector ETFs, however, overexpose investors to the petroleum complex which suffers under a return-eroding “contango.” The equal-weighted GreenHaven Continuous Commodity Index Fund (NYSE Arca: GCC) minimizes this effect to deliver 12-month appreciation of 30.5 percent.

Tom Paine dealt with the Revolutionaries’ crisis in confidence by saying, “I see no real cause for fear. I know our situation well, and can see the way out of it.” Advisors, too, ought to map out positions that allows clients to ride out the buffeting that is bound to occur from time to time. A well-diversified portfolio is more likely to help clients capitalize upon opportunities and mitigate risk, no matter what the economic landscape looks like.

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