How to handle this risky new market

By Jim Jubak

Know what my biggest stock market fear is right now?

That we won't get a correction of 10% or so.

A correction of that size would take some of the hot air out of the current stock market. And it would reduce the chance that the current pyramid of highly leveraged and highly speculative positions in everything from subprime mortgages to Indian stocks will collapse with one big whoosh that takes every asset class with it.

If I'm right about the nature of the global financial markets right now, however, we aren't going to get that 10% correction. The flood of cash sloshing around in the financial markets that I described in my March 6 column, "Drowning in cheap money," will stop the retreat somewhere near the recent 5% marker. The stock market rally will resume. In the debt market, the flight to safety from risky trades will reverse, and investors, traders and speculators will go back to their search for the highest leveraged return, no matter the risk. Emerging stock markets in China, Russia and India, to name just three, will resume zooming. The derivative market will continue to grow by leaps and bounds as investors snap up Wall Street products that promise to pass the risk onto someone else.

And we'll put off the day of reckoning for another day.

How can we strike a balance?

Which leaves me in a quandary that you might recognize: How in a world of increasing financial risk to get a reasonable return on my money -- since I need that return for retirement, saving for college, a down payment, whatever -- without taking on so much risk that I jeopardize my chances of reaching the goals I'm working toward?

This column lays out a strategy for striking the best balance of risk and reward now. My next column will give you 10 specific picks for turning this strategy into an actual portfolio.

I believe that the risk of something bad happening in this market, something worse than the customary 10% correction, is rising. (For a checklist of rising risks, see that March 6 column.)

It's higher than it was three months ago, and if we don't get a 10% correction now, the risk of something truly bad happening will be even greater in three months. I believe that the longer this tide of risk flows higher without a correction, the more likely the eventual reversal will result in a flood sweeping over all asset classes.

The day of reckoning

But the amount of excess liquidity in the world's financial markets makes it likely that the day of reckoning is still a way off. The recent sell-offs in the Shanghai stock market, the reduction in the number of traders borrowing cheap yen, the bankruptcies of several subprime mortgage lenders in the United States and the move toward the safety of Treasury bonds doesn't significantly reduce global supplies of investment cash. A day of reckoning, therefore, could come this year. But it's more likely to take place in 2008 or 2009 -- or even later, say in 2012, when an aging world starts devouring savings rather than generating them.

In the shorter term, however, I think this global liquidity keeps the asset market in bullish mode. There's just too much money chasing too few real investment opportunities for asset prices to head south in the shorter run. The current setbacks to the world's rush to risk are very temporary, I believe. The excesses that I outlined in my last column are likely to be considered tame a year from now, and asset prices are likely to be even higher than they were at the start of the year.

How to plan for the big downturn

I find this depressing because it's not sustainable. Asset prices pumped up by abundant supplies of cheap money fall when the credit cycle turns and money becomes scarcer and more expensive. And the credit cycle will turn. It always does.

I just hope it doesn't turn -- and catch too many investors in its gears -- exactly when an aging world needs to cash out its stocks and bonds, its real estate, its mutual funds and its annuities. That prospect scares me so much that I'd much rather face a 10% correction today than that future tomorrow.

But enough of the fear and doom. Let's talk about what to do now.

I break my approach into three stages, each designed as part of a unified approach to a potential escalation of financial market downturn.

Market Situation No. 1: In the short term, the market stabilizes somewhere around current levels with a 5% retreat.

What to do: What was working in January should start working again, so keep your portfolio pretty much as is, but do get out of the market sectors that are in real distress or that look likely to blow up soon on their own fundamentals.

You've already weathered the pain of a 5% pullback in the market, so if this is as bad as it's going to get, you don't need to overhaul your entire approach to the market (assuming that it's working). Investing strategies, themes and picks that were working in January should start working again as the panic of this sell-off ebbs. But just because the financial markets as a whole stabilize, it doesn't mean that everything is OK again in the sectors that set off the drop to begin with.

So, for example, defaults in the subprime mortgage segment continue to rise. In its most recent filings with the Securities and Exchange Commission, Countrywide Financial (CFC, news, msgs) reported that payments were at least 30 days late on 19% of subprime mortgage loans, up from 15.2% at the end of 2005 and 11.3% at the end of 2004.

What companies will get dinged by the problem? It's extremely hard to tell. (See my video here on why it's so hard to know who is holding the bag.) Some mortgage lenders (such as Citigroup (C, news, msgs) still hold them. Others, such as JPMorgan Chase (JPM, news, msgs), have sold their subprime loans. No one knows for sure who the final buyers are, although informed speculation points to Asian banks and insurance companies. The damage isn't limited to those who originated or bought the mortgages, either.

Packaging mortgages into securities and then manufacturing and selling derivatives based on those securities has been a huge moneymaker for Wall Street. That income stream is quickly drying up for 2007. I'd avoid Citigroup, Lehman Bros. (LEH, news, msgs), Goldman Sachs Group (GS, news, msgs) and Merrill Lynch (MER, news, msgs) in the United States and Barclays (BCS, news, msgs), Deutsche Bank (DB, news, msgs), Royal Bank of Scotland (RBS-L, news, msgs), Credit Suisse Group (CS, news, msgs), UBS AG (UBS, news, msgs), HSBC Holdings (HBC, news, msgs) and Mitsubishi UFJ Financial Group (MTU, news, msgs) in Europe and Asia.

Other sectors to consider selling include biotechnology, emerging markets, coal, home builders and highly leveraged companies no matter what sector they're in, because lenders are going to raise their standards on all kinds of borrowers.

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