Investors, there's no place left to hide

By Jim Jubak

I thought investing in gold, copper, zinc and other commodity stocks was supposed to diversify a portfolio and protect it from falling too far, too fast in a general stock market retreat.

Some protection. Maybe instead of calling it "diversification," they should rename it "di-worsification." Portfolio diversification, that tried-and-true tool for reducing the volatility and risk of a portfolio by making sure that some of what you own will go up even if the rest of it goes down, isn't working too well right now.

Look at these numbers: From Feb. 26 through March 5, with the Dow Jones Industrial Average ($INDU) and the Standard & Poor's 500 Index ($INX) down 5%, gold stocks such as Goldcorp (GG, news, msgs) and Newmont Mining (NEM, news, msgs) fell 15% and 10%, respectively. Copper stocks such as Southern Copper (PCU, news, msgs) and Freeport-McMoRan Copper and Gold (FCX, news, msgs) were down 11% and 14%, respectively.

And these stocks continue to slide faster than stocks as a whole on days when selling rules the stock market. For example, on March 13, when jitters about more defaults and bankruptcies in the subprime mortgage sector sent the Dow Jones industrials to a 243-point, or 2%, tumble, Goldcorp fell an additional 6.5%, and Southern Copper was down 4.7% on the day.

Don't throw it out with the bathwater

So although I don't think it's time to throw the entire strategy of portfolio diversification out with the bathwater, it is time to admit that the classes of assets that we expected to zig when the rest of the market zagged are all moving -- downward, unfortunately -- together. In fact, I'd say that's the hallmark of what is increasingly looking like a full-blown correction in the making is that the standard places to hide aren't offering much shelter.

It's time to reinvent portfolio diversification in order to meet the very specific challenges of this very dangerous crisis.

Let's start with what this market is not. This isn't your standard economy-based correction where frighteningly slow economic growth or frighteningly high inflation sends waves of fear through the stock and bond markets. Diversification works very well in scenarios like that. In fact, that's exactly the kind of market that produced the data that most attempts at portfolio diversification are built on.

Slow growth taking a bit out of technology stocks? No big deal, since you have diversified your portfolio with shares of companies that sell consumer necessities, such as food and beer, that do well at times like these. Higher inflation attacking the prices of retail stocks? Owning shares of gold-mining companies, the classic inflation haven, keep your portfolio on an even keel.

So why aren't these tried-and-true bets working now to buffer portfolios in this downturn?

Because we're suffering through a financial market crisis rooted in the global money supply itself -- and the massive multiplication of that money supply created by easy borrowing. Asset prices are going down now because money has been too cheap for too long. And that makes the standard, economy-based diversification moves irrelevant at best.

The lesson in New Century

The story behind one of the names in the headlines right now, New Century (NEWC, news, msgs), illustrates exactly the nature and causes of the current market sell-off. Five years ago, New Century was a relatively modest player in the home mortgage market, originating just $6.3 billion in loans. By 2006, however, the company was a monster, originating nearly $60 billion in loans.

New Century is structured as a real estate investment trust (REIT), so it passes most of its earnings out to its investors as dividends. So where did New Century get the cash it needed to lend out to the borrowers who took out that $60 billion in loans in 2006?

The company borrowed it -- by issuing debt itself or by selling shares of stock.

Wall Street was only too happy to help out. Investment banks like Morgan Stanley (MS, news, msgs) earned huge fees selling those debt and equity offerings. For the $9.8 billion in capital that Morgan Stanley helped New Century raise since 1998, for example, the company earned $17 million in fees, according to Thomson Financial.

But New Century and companies like it were also a piece of a much bigger profit machine on Wall Street. Portfolio managers around the world, eager to find safe investments that paid more than the paltry 4% to 5% offered by 10-year Treasury bonds, snapped up bundles of mortgages and derivative securities based on mortgages as fast as Wall Street could find them. The faster a company like New Century could write new mortgages, the faster that Wall Street investment banks could bundle them into mortgage-backed assets and sell them to investors.

This was a hugely profitable business for Wall Street in 2006. Fees from underwriting these mortgage-backed securities added up to $2.6 billion last year.

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Able to sell just about as much of these mortgage-backed securities as they could get their hands on -- especially once central banks in Asia began to look for higher yields to offset a falling U.S. dollar -- Wall Street did all that it could to expand supply by increasing the flow of raw materials -- in this case cash -- to companies like New Century.

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