Try cash to capture rising rates

Thursday, the Federal Reserve will announce whether it is raising interest rates for the 17^th time in two years.

The market is betting that it will, and many investors fear more hikes down the road will plunge the nation into recession. "I think the Fed will overdo it," says William V. Fries, co-manager of Thornburg Value Fund (TVAFX). He suspects new Fed Chairman Ben Bernanke will be too hawkish on inflation to establish his central-banker bona fides.

The result of such fears has been a world of worry, and portfolios tilted toward global stocks took a beating in the second quarter. Emerging markets tumbled 8% and Japan was down 6.6%.

The riskiest domestic stocks -- small-company and technology stocks -- were down nearly 6% in the period, as well. Big-capitalization stocks, by contrast, did relatively well, with S&P Depositary Receipts (SPY, news, msgs) (known as Spyders), which track the S&P 500 index, slipping only 3.5%.

(For production reasons, the second quarter here refers to the period March 23 through June 21.)

My model portfolio of exchange-traded funds performed in line with the S&P, ebbing 3.7% in the quarter. The portfolio, which was launched Nov. 28, 2003, with hypothetical assets of $100,000, finished the second quarter worth $128,170, up 1.9% in 2006, ahead of Spyders' 0.8% return.

Despite being overweight foreign stocks, I had also bulked up on cash in the second quarter, and it was the best-performing asset in my portfolio, delivering a solid 1.0% return. Domestic bonds, represented by iShares Lehman Aggregate Fund (AGG), slipped 0.6%.

Cashing in

Here is how the portfolio finished the second quarter:

Note: *Three months ended June 21, 2006; Sources: MSN Money, Morningstar Inc.

Out they go

• iShares MSCI Emerging Markets Index (EEM, news, msgs). As I described in a column last month, a sharp correction in these volatile stocks is usually followed by a prolonged decline. As with the likelihood the Federal Reserve will push interest rates too high, it's probable developing countries will be over-punished.

• iShares MSCI Japan Index (EWJ, news, msgs). I had hoped Japan would become the most successful developed stock market this year, but it has become the biggest failure. When I'm wrong, I say I'm wrong. Out it goes.

• Sallie Mae CPI-Linked Notes (OSM, news, msgs). I asked this agency for information on these hard-to-research securities and it did not provide any. With inflation ticking higher, these notes should be gaining, but they're not. Once again, I was wrong.

Before adding the entire proceeds of these sales (less $10 commissions on each) to cash, I'm going to make one purchase:

• S&P Depositary Receipts (SPY, news, msgs). What transpired in the second quarter has been most-often described as a flight to quality, and no stocks are of higher quality than U.S. blue chips. If the global economy is indeed slowing down, these multinational giants will suffer least. So I'm boosting my portfolio's allocation to these stocks to 15% of total assets, from 9.5% currently.

That means that, on June 21, I bought 57 shares of S&P Depositary Receipts at the closing price of $125.01, bringing my total to 154 shares. I paid a $10 commission. My cash position has swollen to $35,613.08. This is 27.8% of the portfolio's assets, making it the largest position, by far.

• Schwab Value Advantage Money Fund (SWVXX). I am going to invest my imaginary cash in a real money-market fund. As I explained last week, this fund is currently yielding 4.66%. I expect that to rise after Thursday's rate hike.

Using a ticker symbol should also allow us to start showing a percentage return on cash at the dynamic model we maintain in our ETF Center.

Many of us at MSN Money are gloomy about the next few months, and both stocks and bonds could end up under water in 2006. But, assuming a global economic slowdown doesn't get out of control, I would expect next year to be better.

Historically, stocks go up two years for every one year they go down. We've had our share of down lately; let the sunshine in.

At the time of publication Timothy Middleton didn't own any securities mentioned in this article. Middleton is author of "The Bond King: Investment Secrets of PIMCO's Bill Gross," and former mutual-funds columnist for "The New York Times." He works from home in Short Hills, N.J.

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